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Highlights Political and corporate climate activism will increase the cost of developing the resources required to produce and deliver energy going forward – e.g., oil and gas wells; pipelines; copper mines, and refineries. Over the short run, the fastest way for investor-owned companies (IOCs) to address accelerated reductions in CO2 emissions imposed by courts and boards is to walk away from the assets producing them, which could be disruptive over the medium term. Longer term, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources needed to produce and distribute energy. The real difficulty will come in the medium term. Capex for critical metals like copper languishes, just as the call on these metals steadily increases over the next 30 years (Chart of the Week). The evolution to a low-carbon future has not been thought through at the global policy level. A real strategy must address underinvestment in base metals and incentivize the development of technology via a carbon tax – not emissions trading schemes – so firms can innovate to avoid it. We remain long energy and metals exposures.1 Feature And you may ask yourself, "Well … how did I get here?" David Byrne, Once In A Lifetime Energy markets – broadly defined – are radically transforming from week to week. The latest iteration of these markets' evolution is catalyzed by climate activists, who are finding increasing success in court and on corporate boards – sometimes backed by major institutional investors – and forcing oil and gas producers to accelerate CO2 emission-reduction programs.2 Climate activists' arguments are finding increasing purchase because they have merit: Years of stiff-arming investors seeking clarity on the oil and gas producers' decarbonization agendas, coupled with a pronounced failure to provide returns in excess of their cost of capital, have given activists all of the ammo needed to argue their points. Chart of the WeekCall On Metals For Energy Will Increase This activism is not limited to the courts or boardrooms. Voters in democratic societies with contested elections also are seeking redress for failures of their governments to effectively channel mineral wealth back into society on an equitable basis, and to protect their environments and the habitats of indigenous populations. This voter activism is especially apparent in Chile and Peru, where elections and constitutional conventions likely will result in higher taxes and royalties on metals IOCs operating in these states, which will increase production costs and ultimately be passed on to consumers.3 These states account for ~ 40% of world copper output. IOCs Walk Away Earlier this week, Exxon walked away from an early-stage offshore oil development project in Ghana.4 This followed the unfavorable court rulings and boardroom setbacks experienced by Royal Dutch Shell, Chevron and Exxon recently (referenced in fn. 2). While the company had no comment on its abrupt departure, its action shows how IOCs can exercise their option to put a project back to its host government, thus illustrating one of the most readily available alternatives for energy IOCs to meet court- or board-mandated CO2 emissions targets. If these investments qualify as write-offs, the burden will be borne by taxpayers. As climate activism increases, state-owned companies (SOCs) not facing the constraints of IOCs likely will be required to provide an increasing share of the resources – particularly oil and gas – needed to produce and distribute energy going forward. This is not an unalloyed benefit, as the SOCs still face stranded-asset risks, if they invest in longer-lived assets that are obviated by a successful renewables + grid buildout globally. That is a cost that will have to be compensated, when the SOCs work up their capex allocations. Still, if legal and investor activism significantly accelerates IOCs' capex reductions in oil and gas projects, the SOCs – particularly those in OPEC 2.0 – will be able to expand their position as the dominant supplier in the global oil market, and could perhaps increase their influence on price levels and forward-curve dynamics (Chart 2).5 Chart 2OPEC 2.0s Could Expand If Investor Activism Increases Higher Call On Metals At present, there is a lot of talk about the need to invest in renewable electricity generation and the grid structure supporting it, but very little in the way of planning for this transition. Other than repeated assertions of its necessity, little is being said regarding how exactly this strategy will be executed given the magnitude of the supply increase in metals required. Nowhere is this more apparent than in the refined copper market, which has been in a physical deficit – i.e., production minus consumption is negative – for the last 6 years (Chart 3). Physical copper markets in China, which consumes more than 50% of refined output, remain extremely tight, as can be seen in the ongoing weakness of treating charges and refining charges (TC/RC) for the past year (Chart 4). These charges are inversely correlated to prices – when TC/RCs are low, it means there is surplus refining capacity for copper – unrefined metal is scarce, which drives down demand for these services. Chart 3Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains TightTheoretically, high prices will incentivize higher levels of production. However, after the last decade’s ill-timed investment in new mine discoveries and expansions, mining companies have become more wary with their investments, and are using earnings to pay dividends and reduce debt. This leads us to believe that mining companies will not invest in new mine discoveries but will use capital expenditure to expand brownfield projects to meet rising demand. In the last decade, as copper demand rose, capex for copper rose from 2010-2012, and fell from 2013-2016 (Chart 5). During this time, the copper ore grade was on a declining trend. This implies that the new copper brought online was being mined from lower-grade ore, due to the expansion of existing projects(Chart 6). Chart 5Copper Capex Growth Remains Weak Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle Capex directed at keeping ore production above consumption will not be sufficient to avoid major depletions of ore supplies beginning in 2024, according to Wood Mackenzie. The consultancy foresees a cumulative deficit of ~ 16mm MT by 2040. Plugging this gap will require $325-$500 billion of investment in the copper mining sector.6 The Case For A Carbon Tax The low-carbon future remains something of a will-o'-the-wisp – seen off in the future but not really developed in the present. Most striking in discussions of the low-carbon transition is the assumption of resource availability – particularly bases metals –in, e.g., the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector, published last month. In the IEA's document, further investment in hydrocarbons is not required beyond 2025. The copper, aluminum, steel, etc., required to build the generation and supporting grid infrastructure will be available and callable as needed to build all the renewable generation the world requires. The document is agnostic between carbon trading and carbon taxes as a way to price carbon and incentivize the technology that would allow firms and households to avoid a direct cost on carbon. A real strategy must address the fact that most of the world will continue to rely on fossil fuels for decades, as development goals are pursued. Underinvestment in base metals and its implications for the buildout of generation and grids has to be a priority if these assets are to be built. Given the 5-10-year lead times base metals mines require to come online, it is obvious that beyond the middle of this decade, the physical reality of demand exceeding supply will assert itself. A good start would be a global effort to impose and collect carbon taxes uniformly across states.7 This would need to be augmented with a carbon club, which restricts admission and trading privileges  to those states adopting such a scheme. Harmonizing the multiple emissions trading schemes worldwide will be a decades-long effort that is unlikely to succeed. Such schemes also can be gamed by larger players, producing pricing distortions. A hard and fast tax that is enforced in all of the members of such a carbon club would immediately focus attention on the technology required to avoid paying it – mobilizing capital, innovation and entrepreneurial drive to make it a reality. This would support carbon-capture, use and storage technologies as well, thus extending the life of existing energy resources as the next generation of metals-based resources is built out. In addition, a carbon tax raises revenue for governments, which can be used for a variety of public policies, including reducing other taxes to reduce the overall burden of taxation. Lastly, a tax eliminates the potential for short-term price volatility in the pricing of carbon – as long as households and firms know what confronts them they can plan around it.  Tax revenues also can be used to reduce the regressive nature of such levies. Investment Implications The lack of a coherent policy framework that addresses the very real constraints on the transition to a low-carbon economy makes the likelihood of a volatile, years-long evolution foreordained. We believe this will create numerous investment opportunities as underinvestment in hydrocarbons and base metals production predisposes oil, natural gas and base metals prices to move higher in the face of strong and rising demand. We remain long commodity index exposure – the S&P GSCI and GSCI Commodity Dynamic Roll Strategy ETF (COMT), which is optimized to take advantage of the most backwardated commodity forward curves in the index. These positions were up 5.3% and 7.2% since inception on December 7, 2017 and March 12, 2021, respectively, at Tuesday's close. We also remain long the MSCI Global Metals & Mining Producers ETF (PICK), which is up 33.9% since it was put on December 10, 2020. Expecting continued volatility in metals – copper in particular – we will look for opportunities to re-establish positions in COMEX/CME Copper after being stopped out with gains. A trailing stop was elected on our long Dec21 copper position established September 10, 2020, which was closed out with a 48.2% gain on May 21, 2021. Our long calendar 2022 vs short calendar 2023 COMEX copper backwardation trade established April 22, 2021, was closed out on May 20, 2021, leaving us with a return of 305%.   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 OPEC 2.0 offered no surprises to markets this week, as it remained committed to returning just over 2mm b/d of production to the market over the May-July period, 70% of which comes from the Kingdom of Saudi Arabia (KSA), according to Platts. While Iran's return to the market is not a given in OPEC 2.0's geometry, we have given better than even odds it will return to the market beginning in 3Q21 and restore most of the 1.4mm b/d not being produced at present to the market over the course of the following year. OPEC itself expects demand to increase 6mm b/d this year, somewhat above our expectation of 5.3mm b/d. Stronger demand could raise Brent prices above our average $63/bbl forecast for this year (Chart 7). Brent was trading above $71/bbl as we went to press. Base Metals: Bullish BHP declared operations at its Escondida and Spence mines were running at normal rates despite a strike by some 200 operations specialists. BHP is employing so-called substitute workers to conduct operation, according to reuters.com, which also reported separate unions at both mines are considering strike actions in the near future. Precious Metals: Bullish The Fed’s reluctance to increase nominal interest rates despite indications of higher inflation will reduce real rates, which will support higher gold prices (Chart 8). We agree with our colleagues at BCA Research's US Bond Strategy that the Fed is waiting for the US labor market to reach levels consistent with its assessment of maximum employment before it makes its initial rate hike in this interest-rate cycle. Subsequent rate changes, however, will be based on realized inflation and inflation expectations. In our opinion, the Fed is following this ultra-accommodative monetary policy approach to break the US liquidity trap, brought about by a rise in precautionary savings due to the pandemic. In addition, we continue to expect USD weakness, which also will support gold and precious metals prices. We remain long gold, expecting prices to clear $2,000/oz this year. Ags/Softs: Neutral Corn prices fell more than 2% Wednesday, following the release of USDA estimates showing 95% of the corn crop was planted by 31 May 2021, well over the 87% five-year average. This was in line with expectations. However, the Department's assessment that 76% of the crop was in good-to-excellent condition exceeded market expectations. Chart 7 Chart 8 Footnotes 1     Please see Trade Tables below. 2     Please see OPEC, Russia seen gaining more power with Shell Dutch ruling and EXCLUSIVE BlackRock backs 3 dissidents to shake up Exxon board -sources published by reuters.com June 1, 2021 and May 25, 2021. 3    Please see Chile's govt in shock loss as voters pick independents to draft constitution published by reuters.com May 17, 2021, and Peru’s elite in panic at prospect of hard-left victory in presidential election published by ft.com June 1, 2021.  Peru has seen significant capital flight on the back of these fears.  See also Results from Chile’s May 2021 elections published by IHS Markit May 21, 2021 re a higher likelihood of tax increases for the mining sector.  The risk of nationalization is de minimis, according to IHS. 4    Please see Exxon walks away from stake in deepwater Ghana block published by worldoil.com June 1, 2021. 5    Please see OPEC 2.0's Production Strategy In Focus, which we published on May 20, 2021, for a recap our how we model OPEC 2.0's strategy.  It is available at ces.bcaresearch.com. 6    Please see Will a lack of supply growth come back to bite the copper industry?, published by Wood Mackenzie on March 23, 2021. 7     Please see The Challenges and Prospects for Carbon Pricing in Europe published by the Oxford Institute for Energy Studies last month for a discussion of carbon taxes vs. emissions trading schemes.     Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar

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

Highlights Domestic and foreign supply-side constraints are now exerting a significant effect on the US economy. Consumer prices may increase at a faster pace than we initially expected over the coming 3-4 months, but supply-side constraints are likely to wane later this year and thus do genuinely appear to be transitory. The idea that even a temporary period of high inflation could persist over the longer term has legitimate grounding in macro theory, and is explicitly recognized in the Fed’s inflation framework. But it would necessitate a very large increase in inflation expectations, which have yet to rise to abnormal levels. The baseline for inflation has shifted back closer to the Fed’s target, but deviations above or below target over the coming 12-18 months are likely to be driven by demand-side rather than supply-side factors. The Fed’s checklist for liftoff now entirely depends on employment, and there are compelling arguments in favor of outsized jobs growth in the second half of the year that would move forward the timing of the first rate hike. But the reality for investors is that there is tremendous uncertainty concerning the magnitude of these job gains, given the likelihood of some lasting changes to consumer behavior following the pandemic. Visibility about the employment consequences of these changes will remain very low until investors receive more information about likely urban office footprint and downtown commuter presence, the speed at which international travel will return, and to what degree any pandemic control measures remain in place in the second half of the year. For now, investors should remain cyclically overweight stocks versus bonds, short duration, and invested in other procyclical positions, with an eye to reassess the monetary policy and growth outlook in the late summer / early fall. Feature Chart I-1Investors Have Focused On The April Jobs And Inflation Data Investors’ attention in May was focused squarely on two, ostensibly contradictory US data surprises: an extremely disappointing April jobs report, and a surge in consumer prices (Chart I-1). Abstracting from the typically lagging nature of consumer prices, a weak labor market is typically disinflationary / deflationary, not inflationary. But this is only to be expected in a typical environment where demand-side factors are predominantly driving the jobs market and the pricing decisions of firms, and the April data has made it clear that domestic and foreign supply-side constraints are now exerting a significant effect on the US economy, more forcefully than we initially thought. This warrants a further analysis of our prior view that supply-side effects would have a moderate effect on activity and prices this year, which we present below. A Deep Dive Into April’s Employment And Inflation Data Chart I-2 shows the difference between the April monthly gain in US jobs by industry compared with those of March. Almost all US industries saw a slower pace of jobs gains in April than March, but the slowdown was particularly acute in the professional & business services, transportation & warehousing, education & health services, construction, and manufacturing industries. By contrast, leisure & hospitality, the industry with the largest employment gap relative to pre-pandemic levels, saw a faster pace of April job gains relative to March. Chart I-2Breaking Down Disappointing April Payroll Gains In our view, several facts from the April jobs report characterize the labor market as being in a transition towards a post-pandemic state, but also legitimately impacted by labor supply constraints at the low-skilled and blue-collar levels: Within professional & business services, almost all of the slowdown in monthly job gains occurred within temporary help services. Temp help services is a cyclical employment category over the longer-term, but over short periods of time it can also be negatively correlated with gains in full-time positions. April saw a large decline in the number of employed persons at work part time, suggesting that the slowdown in temp help may reflect a shift back to full-time work. Within transportation & warehousing, the slowdown in jobs was entirely attributed to the couriers and messengers subsector, which includes delivery services. In combination with the acceleration in jobs in the leisure & hospitality sector, this likely reflects a shift away from home food delivery towards in-person restaurant orders and the use of aggressive hiring tactics by restaurant owners (including advertisements of cash bonuses following 90 days of completed work, paid vacations, health insurance, and other perks). The slowdown in jobs growth in the construction & manufacturing industries is likely due to two, separate supply constraints: the negative impact of higher input costs such as lumber, semiconductors, and other raw materials, as well as the disincentivizing effects of supplementary unemployment benefits that appears to be limiting the willingness of lower-wage workers to return to work. Chart I-3April's Rise In Core CPI Was Extreme, Even After Removing Some Outliers On the inflation front, Chart I-3 highlights that the April surge in core consumer prices did not just occur because of year-over-year base effects, but because of significant month-over-month increases in prices. Outsized gains in used car prices driven by the impact of the semiconductor shortage on new car production, as well as surging airline fares, did significantly contribute to April’s month-over-month gain, but the dotted line in the chart highlights that the monthly change would still have been extreme relative to history even if these components had increased instead at a 2% annual rate. Taken together, the April employment and inflation data, in conjunction with surveys of US firms as well as the trend in commodity prices, suggest that the labor market and consumer prices are being affected by four separate but related factors: An underlying demand effect, driven by extremely stimulative fiscal & monetary policy as well as economic reopening; A domestic labor shortage Coordination failures and bottlenecks impacting the production of key supply chain components and resource inputs Coordination failures and bottlenecks impacting the logistics of international trade Strong domestic aggregate demand is not likely to wane over the coming 6-12 months, which has been the basis for our view that inflation would rise to modestly above-target levels this year. Given this new evidence of their prominence and impact, it does seem likely that the remaining three supply-side factors will persist for a few more months, suggesting that core inflation may remain quite elevated over the near term. But several points underscore why it remains difficult to accept a view that supply-side factors will remain an important driver of employment and consumer price trends on a 1-year time horizon. Chart I-4Home Schooling Is Impacting The Labor Market First, domestic labor shortages are occurring in the context of a gap of 8.2 million jobs relative to pre-pandemic levels, underscoring that substantial barriers to returning to work exist. The three most cited barriers are an unwillingness to return to employment for health reasons, an unwillingness to return to work because of supplementary unemployment insurance benefits that are in excess of regular income, and an inability to return to work due to childcare requirements. For example, Chart I-4 highlights that the labor force participation rate has declined the most for women with young children, whose children in many cases are being schooled online rather that in person. But all three of these factors are clearly linked to the pandemic, and are likely to be greatly reduced (or eliminated) in the fall once schools have reopened and income support has ended. Federal supplementary UI benefits are set to expire by labor day, and several US states have already opted out of the program – with benefits set to end in June or July.1 Second, global producers of important commodity inputs (such as lumber) significantly cut production last year under the expectation that the pandemic would greatly reduce spending, only to be whipsawed by a surge in demand stemming from a combination of working from home effects and a massive policy response. Chart I-5 highlights that US industrial production of wood products fell to -10% on a year-over-year basis last April, but that it has subsequently rebounded to a new high. Unlike other supply chain inputs, global semiconductor sales did not decline last April (in the face of enormous PC, tablet, and server/data center demand), but Chart I-6 highlights that DRAM prices, lumber prices, and prices of raw industrial goods may be peaking or have already peaked. Chart I-5Lumber Prices Are Soaring, In Part, Because Supply Was Cut Last Year Chart I-6Costs of Key Inputs May Be Peaking (Or Have Peaked) Chart I-7Logistical Issues, Which Will Be Resolved, Are Driving Shipping Costs Third, while some market participants have attributed the enormous rise in global shipping costs entirely to the underlying demand effect that we noted above, Chart I-7 highlights that this is clearly not the case. The chart shows that the surge in loaded inbound container trade to the Los Angeles and Long Beach ports, to its strongest level since the inception of the data in the mid 1990s, could potentially explain a 75-100% year-over-year rise in shipping costs – less than half of the 250% surge that has occurred over the past 12 months. This strongly points to logistical issues such as the incorrect positioning of cargo containers amid pandemic-related port congestion (and other disruptions such as the temporary grounding of the Ever Given in the Suez canal) as the dominant driver of global shipping costs, which have likely pushed up US non-oil import prices by more than what would normally be implied by the decline in the US dollar (Chart I-8). Global shipping costs have yet to peak, but we expect that these logistical problems will likely be resolved sometime in Q3, or potentially over the summer. This view is underpinned by the fact that the number of global container ships arriving on time rose in March, the first month-over-month increase since June of last year.2 Chart I-8Rising Transport Costs Have Pushed Up US Import Prices For investors, the key conclusion of this review is that while consumer prices may increase at a faster pace than we initially expected over the coming 3-4 months, supply-side factors are clearly driving outsized gains, and have likely or definite end points before the end of the year. As such, despite the surprising magnitude of these supply-side factors, they do genuinely appear to be transitory. The “Transitory” Debate Most investors would agree that 3-4 months of outsized consumer price increases would not be, in and of themselves, economically significant or investment relevant. But the question of whether even a temporary period of high inflation could persist over a 12-month or multi-year time horizon has become prominent in the marketplace, with some investors believing that it has high odds of fueling an already-established, demand-side narrative supporting higher prices in a way that becomes self-reinforcing among consumers and firms. Indeed, this view has a legitimate grounding in macro theory, and is explicitly recognized in the Fed’s inflation framework – which is called the expectations-augmented or Modern-Day Phillips Curve (“MDPC”). In anticipation of the coming debate about inflation and its causes, we thoroughly reviewed the MDPC in our January report.3 One crucial takeaway from the MDPC framework is that economic activity relative to its potential determines the degree to which inflation deviates from expectations of inflation, not the Fed’s inflation target. If, for example, inflation expectations are meaningfully below target, then the Fed would need to aim for an unemployment rate below its natural rate for some period of time in an attempt to re-anchor expectations closer to its target rate (based on the view that inflation expectations adapt to the actual inflation experience). This is essentially what occurred in the latter half of the last economic expansion, and is what motivated the Fed’s shift to its average inflation targeting regime. The Modern-Day Phillips Curve is “modern” because of the experience of inflation in the late 1960s and 1970s, where ever-rising expectations for inflation (alongside extremely easy monetary policy) became self-reinforcing and caused core PCE inflation to rise to high single-digit territory in the second half of the decade. Thus, the notion that elevated consumer prices over the short-term could increase actual inflation over the longer term via higher expectations – meaning that it would not be transitory – is plausible. Chart I-9The Fed's New Index Of Common Inflation Expectations (CIE) Is it likely? In our view, while the odds have increased somewhat over the past month, the answer is no. Chart I-9 presents the Fed’s quarterly index of common inflation expectations (CIE), alongside a model designed to track movements in the index on a monthly frequency. While the Fed’s index includes over 21 inflation expectation indicators, our condensed model uses just six: the 10-year annualized rate of change in headline inflation, the 10-year annualized rate of change in the headline PCE deflator, 5-year/5-year forward and 10-year/10-year forward TIPS breakeven inflation rates, the 3-month moving average of long-term surveyed consumer expectations for inflation, and a proprietary measure of inflation expectations based on an adaptive expectations framework. Chart I-10 highlights that among these six series (shown standardized since mid 2004), three of them have risen quite significantly over the past year: long-dated TIPS breakeven inflation rates (5-5 and 10-10), and long-term consumer expectations for inflation. In our view, the latter series from the University of Michigan is one of the most important for investors to monitor over the coming year, as it is one of the few available measures of “main-street” inflation expectations with a long history. Chart I-10Important Drivers Of The CIE Index Have Risen, But From A Low Base Chart I-11A Deeply Negative Output Gap Last Cycle Made Inflation Expectations Vulnerable To Shocks But while the series in the top panel of Chart I-10 have risen sharply, they are rising from an extremely low base and are currently only fractionally above their average since 2004. As noted in our January report, inflation expectations fell significantly in 2014 first because they were highly vulnerable to shocks following a long period of a deeply negative output gap (Chart I-11), and second because they were catalyzed by a substantial US dollar / oil price shock that occurred in that year. We noted above that the odds of extreme near-term price changes ultimately becoming non-transitory have risen somewhat, and Chart I-12 highlights why. The chart presents the annual change in long-term consumer expectations of inflation alongside the annual change in 2-year government bond yields, and notes that the past three cases of a similar-sized spike in expectations were all ultimately met with either a significant rise in short-term interest rates or a major deflationary shock – neither of which we expect to occur over the coming year. Chart I-12Other Consumer Price Expectation Spikes Have Been Met By Rising Rates Or A Deflationary Shock However, the fact that the rise in expectations clearly has a mean-reversion component to it, and that the supply-side factors driving month-over-month price increases are temporary in nature, argues against the idea that expectations will rise above the average that prevailed from 2002 – 2014. This suggests that while the baseline for inflation has moved back closer to the Fed’s target, deviations above or below target are likely to be driven by demand-side rather than supply-side factors. The Fed’s Checklist: Focus On Employment Table I-1The Fed’s Checklist For Liftoff From an investment perspective, the outlook for inflation is important mostly because of its implications for Fed policy, and thus interest rates and equity valuation multiples. My colleague Ryan Swift, BCA’s US Bond Strategist, has presented the Fed’s checklist for liftoff in Table I-1. The Fed has been explicit that they will not raise interest rates until all three boxes are checked, regardless of what is occurring to inflation expectations or actual inflation. The first box in the list is essentially checked, as tomorrow’s April Personal Income and Outlays report will very likely confirm that the core PCE deflator rose in excess of 2% (the headline PCE deflator was already in excess of this in March). And the third criterion is essentially a derivative of the other two, barring the emergence of a significant deflationary shock at the time that the Fed would otherwise begin to raise rates. This means that investors should be entirely focused on labor market developments, and whether they are consistent with the Fed’s assessment of maximum employment. Table I-2 highlights the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 3.5-4.5%, the range of the Fed’s NAIRU estimates. The table underscores that large gains will be required for the Fed’s maximum employment criteria to be met by the end of this year or year-end 2022, on the order of 410-830k per month. Table I-2Calculating The Distance To Maximum Employment But the nature of the pandemic and the factors that drove what is still an 8.2 million jobs gap underscore the extreme difficulty in forecasting what monthly job gains are likely to occur on average over the coming 12-18 months. From March to August of last year, monthly changes in nonfarm payrolls exceeded +/-1 million per month, with 20.7 million jobs lost in the month of April 2020 alone. Payroll gains averaged 3.8 million per month in the two months that followed, and if that pace were to be repeated this fall as schools reopen and supplementary unemployment benefits draw to a close in all states it would close 93% of the outstanding jobs gap. This implies that monthly job growth will follow a bimodal distribution over the coming year, with large gains in Q3/Q4 followed by a much more normal pace of jobs growth in Q1/Q2 2022. In our view, the outlook for Fed policy depends significantly on the magnitude of those outsized gains in employment this fall, and there are three main arguments favoring a larger pace of monthly job growth during this period. First, Table I-3 highlights that the jobs gap is most prominent in the leisure & hospitality, government, education & health services, and professional & business services industries, and several observations suggest that Q3/Q4 job gains in these sectors may be sizeable: Table I-3Breaking Down The Pandemic Employment Gap By Industry 70% of the government employment gap shown in Table I-3 can be attributed to education, as government employment also includes education employment at the state and local government level. Many of these jobs, along with those in the education & health services industry, are likely to recover in the fall as schools reopen across the country. As noted in our discussion of the April jobs data, the professional & business services industry includes the “administrative & support services” sector, which accounts for 85% of the overall job gap for the industry. These jobs have likely been impacted heavily by reduced office presence as well as business travel, and may recover further in the fall as many employees shift partially or fully away from working from home. Chart I-13Leisure & Hospitality Employment Is Closely Tracking Hotel Occupancy Chart I-13 highlights that the year-over-year growth rates of leisure & hospitality employment and the US hotel occupancy rate are tracking each other quite closely, and that the latter is in a solid uptrend.4 While international travel is likely to remain muted this summer, the rebound in hotel occupancy suggests that Americans are choosing to travel domestically this year and that further gains in occupancy may occur over the coming months. Chart I-14 highlights the second argument in favor of a larger pace of monthly job growth in the second half of the year. The chart shows the clear relationship between reopening and the employment gap, with states that have fully reopened having substantially smaller gaps than states that have not. It is true that some states that have fully reopened are still experiencing a sizeable gap, but this is at least in part due to leisure & hospitality employment that is dependent on the travel patterns of consumers. For example, Nevada still has a 10% employment gap despite having fully reopened, clearly reflecting the impact of reduced tourism to Las Vegas. Thus, as all states move towards being fully reopened later this year, including large states such as New York and California, Chart I-14 suggests that the US jobs gap is likely to narrow significantly. Chart I-14US States That Have Reopened Have A Smaller Employment Gap Chart I-15Real Output Per Worker Is Not Likely To Rise Further Finally, Chart I-15 highlights that the 2020 recession is the only one in which real output per person rose sharply during the recession. It is true that productivity tends to rise over time and that it usually increases in the early phase of an economic recovery, but the rise in real output per worker last year clearly reflects the massive decline in employment and services spending that resulted from pandemic-related control measures and lockdowns. Our sense is that this sharp rise in real output per worker is not likely to be sustained following full reopening and the elimination of barriers to employment, and if real output per worker were to even modestly converge to its prior trend (the dotted line in Chart I-15) it would more than fully close the jobs gap shown in Table I-3 by the end of the year based on consensus growth forecasts for this year. Investment Conclusions Despite compelling arguments for outsized jobs growth in the second half of the year, the bottom line for investors is that there is tremendous uncertainty concerning its magnitude. It seems likely that there will be some lasting changes to consumer behavior following the pandemic, and visibility about the employment consequences of these changes will remain very low until investors receive more information about the likely urban office footprint and downtown commuter presence, the speed at which international travel will return, and the degree to which any pandemic control measures remain in place in the second half of the year. Given the Fed’s criteria for liftoff, developments that imply a pace of jobs recovery that is in line with or slower than the Fed’s unemployment rate projections will ensure that the monetary policy regime will remain supportive of risky asset prices over the coming year. If the employment gap closes rapidly in Q3/Q4, then investor expectations for the timing of the first rate hike will move sharply closer, which could act as a negative inflection point for stock prices. This is now more probable than it was a month ago, as Chart I-16 highlights that the OIS curve has shifted towards expectations of an initial rate hike at the end of next year or early 2023, from mid 2022 previously. Chart I-16Market Rate Hike Expectations Have Shifted Back To Late 2022 / Early 2023 Still, abstracting from knee-jerk market reactions, it is the pace of hikes and investor expectations for the terminal Fed funds rate that are the more important fundamental drivers of 10-year Treasury yields, and investors would need to see a very large revision to the latter in order for yields to rise to a point that would restrict economic activity or threaten equity market multiples. Such a revision is highly unlikely over the summer unless incoming evidence strongly suggests that the employment gap will be closed by the end of the year. As highlighted above, this may indeed occur later in the year, but probably not over the coming 3 months. For now, investors should remain cyclically overweight stocks versus bonds, short duration, and invested in other procyclical positions, with an eye to reassess the monetary policy and growth outlook in the late summer / early fall. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst May 27, 2021 Next Report: June 24, 2021 II. Global House Prices: A New Threat For Policymakers House prices are rising rapidly across the developed markets, in response to the extraordinary monetary and fiscal policy stimulus implemented to fight the pandemic. Evidence points to the house price surge being driven by monetary policy that has left real interest rates far below equilibrium levels. Supply factors are a secondary cause of the house price boom. Financial stability risks stemming from rising house prices are less acute than the pre-2008 experience, as overall household leverage has grown more slowly during the pandemic and global banks are better capitalized. Rapidly rising house prices are forcing some central banks to turn less accommodative earlier than expected. The recent hawkish turns by the Bank of Canada and Reserve Bank of New Zealand may be canaries in the coal mine for other central banks – perhaps even the Fed – if house prices and household leverage start rising together. The COVID-19 pandemic led to the sharpest economic recession since World War II, alongside an enormous rise in unemployment. Consensus expectations call for the output gap to be closed (or mostly closed) in most advanced economies by the end of this year, but it remains an open question how quickly these economies will be able to return to full employment amid potentially permanent shifts in demand for office space and goods sold at physical, “brick and mortar” retail locations. Despite this sizeable and swift economic shock, house price appreciation accelerated last year in the developed world. Chart II-1 highlights that US house prices rose at an 18% annualized pace in the second half of 2020, whereas they accelerated at a high-single digit pace in developed markets ex-US (on a GDP-weighted basis). This, in conjunction with a sharp rise in the household sector credit-to-GDP ratio (Chart II-2), has unnerved some investors while raising questions about the implications for monetary policy. Chart II-1House Prices Are Surging Around The World Chart II-2Rising Fears About Deteriorating Household Balance Sheets Before we discuss the investment implications of the global housing boom, however, we must first accurately determine the reasons why it is happening. The Work-From-Home Effect: Less Than Meets The Eye When analyzing the surprising behavior of the housing market last year, the working-from-home effect brought upon by the pandemic emerges as an obvious factor potentially explaining house price gains. Last year, following recommended or mandatory stay-at-home orders from governments, most office-based businesses rapidly shifted to work-from-home arrangements as an emergency response. However, in the month or two following the beginning of stay-at-home orders, several national US surveys found many office workers preferred the flexibility afforded by work-from-home arrangements. Many employers, correspondingly, found that the productivity of their employees did not suffer while working from home, or that it even improved. Several prominent corporations in the US have subsequently made some work-from-home options permanent, or even allowed employees to work from offices in a different city than they did prior to the pandemic. Newfound work-from-home options have undoubtedly created new demand for housing, and thus explained the surge in house prices seen over the past year in the minds of some investors. However, in our view, evidence from the US, the UK, and France suggests that the work-from-home effect better explains differences in price gains across housing types and within large metropolitan areas, rather than aggregate or national-level changes in house prices. Chart II-3 provides some quantification of the impact of work-from-home policies by plotting US resident migration patterns by city. This data has been compiled by CBRE, and the impact of COVID is shown as the change in net move-ins from 2019 to 2020 per 1000 people. This helps control for the underlying migration pattern that existed in US cities prior to the pandemic. Chart II-3Work From Home Policies Have Impacted Migration Trends… The chart highlights that the negative migration impact from COVID has been mostly concentrated in New York City and the three most populous cities on the West Coast (by metro area): Los Angeles, San Francisco, and Seattle. And yet, Chart II-4 highlights that house price inflation in these four cities has accelerated to a double-digit pace, only modestly below the national average. Chart II-4...But Cities With Outward Migration Still Have Very Strong House Price Gains The house price indexes shown in Chart II-4 represent aggregate, metro area trends, and clearly some regions within these metro areas have experienced house price deceleration or outright deflation versus gains in areas outside the urban core. But Chart II-5 highlights that house prices have declined in Manhattan basically in line with the change in net move-ins as a share of the population, underscoring that double-digit metro area-wide house price gains appear to be vastly disproportionate to changes in net migration. Similarly, Chart II-6 highlights that rents decelerated in the US over the past year but remained in positive territory and grew at a 3.5% annualized rate from February to April. Chart II-5In Manhattan, House Prices Have Tracked Net Migration Chart II-6Rent Costs Have Decelerated, But Have Not Contracted Evidence from Paris and London also suggests that a work-from-home effect is insufficient to explain broad house price gains. Panel 1 of Chart II-7 highlights that house prices in France have accelerated significantly, but that apartment prices have decelerated only fractionally in lockstep. Panel 2 shows that the acceleration in house prices does reflect a work-from-home effect, as prices have risen faster in inner Parisian suburbs. Panel 3, however, highlights that Parisian apartment prices, the dominant property type in the urban core, have decelerated modestly. Chart II-8 highlights that house price gains have not even decelerated in greater London; they have been merely been modestly outstripped by gains in Outer South East (outside of the Outer Metropolitan Area). Chart II-7In France, Parisian Apartment Prices Are Simply Lagging, Not Falling Chart II-8In The UK, Greater London Property Prices Are Accelerating     The Policy Effect: The Fundamental Driver Of The Housing Market Despite the broader location flexibility that work-from-home policies now provide to potential homeowners, it seems inconceivable that the housing market would have responded in the manner that it has over the past year given the size of the economic shock brought on by the pandemic without significant support from policy. Above-the-line fiscal measures to the pandemic have totaled in the double-digits in advanced economies (Chart II-9), and monetary policy has contributed to easier financial conditions via rate cuts, asset purchases, and sizeable programs to support financial market liquidity. Chart II-9There Has Been A Massive Fiscal Policy Response To The Crisis In fact, Charts II-10-II-13 present compelling evidence that fiscal and monetary policy have been the core drivers of significant house price gains over the past year. Charts II-10 and II-11 plot the above-the-line fiscal response of advanced economies against the year-over-year growth rate in house prices as well as its acceleration (the change in the year-over-year growth rate). The charts show a clearly positive relationship, with a stronger link between the pandemic fiscal response and the acceleration in house prices. Chart II-10Differences In Last Year’s Fiscal Response… Chart II-11…Help Explain Differences In House Price Gains Chart II-12Pre-Pandemic Differences In The Monetary Policy Stance… Chart II-13…Do An Even Better Job Of Explaining 2020 House Price Gains   Charts II-12 and II-13 highlight the even stronger link between house prices and the pre-pandemic monetary policy stance in advanced economies, defined as the difference between each country’s 2-year government bond yield and its Taylor Rule-implied policy interest rate as of Q4 2019. We construct each country’s Taylor Rule using the original specification, with core consumer price inflation, a 2% inflation target, and real potential GDP growth as the definition of the real equilibrium interest rate. The charts make it clear that easy monetary policy strongly explains house price gains in 2020, particularly the year-over-year percent change rather than its acceleration. This makes sense, given that monetary policy was already quite easy in many countries at the onset of the pandemic – meaning that changes were less pronounced than they would have been had interest rates been higher. The explanation that emerges from Charts II-10-II-13 is that historic fiscal easing, combined with an easy starting point for monetary policy – that became even easier last year – enabled demand from work-from-home policies to manifest during an extremely severe recession. We agree that work-from-home policies have shifted the geographic preferences of some home buyers and likely provided a new source of net demand from renters in urban cores purchasing homes in outlying areas. But we strongly doubt that the net effect of work-from-home policies in the midst of an extreme shock to economic activity would have caused the rise in house prices that we have observed, certainly not to this level, without major support from policy. This underscores that policy, and not the work-from-home effect, has and will likely remain the core driver of the global housing market. The Supply Effect: Mostly A Red Herring Chart II-14Countries Fall Into Two Groups In Terms Of The Relative Trend In Real Residential Investment One perennial question that emerges when analyzing the housing market, particularly in markets with outsized house price gains, is the impact of constrained supply. It is frequently argued that constrained supply is squeezing prices higher in many markets, and that the appropriate policy solution to extreme house price gains is to enable widespread housing construction – not to raise interest rates. We do not rule out the potential impact of constrained supply in certain cities or regional housing markets, and we have highlighted in previous research that a positive relationship does exist between population density in urban regions and median house price-to-income ratios.5 But as a broad explanation for supercharged house price gains, the supply argument appears to fall flat. Chart II-14 presents the most standardized measure of cross-country housing supply available for several advanced economies, the trend in real residential investment relative to real GDP over time. These series are all rebased to 100 as of 1997, prior to the 2002-2007 US housing market boom. The chart makes it clear that advanced economies generally fall into two groups based on this metric: those that have seen declines in real residential investment relative to GDP, especially after the global financial crisis (panel 1), and those that have experienced either an uptrend in housing construction relative to output or have seen a flat trend (panel 2). If scarce housing supply was the core driver of outsized house price gains, then we would expect to see stronger gains in the countries shown in panel 1 and smaller gains in the countries shown in panel 2. In fact, mostly the opposite is true: Charts II-15 and II-16 highlight that the relationship between the level of these indexes today relative to their 1997 or 2005 levels is positively related to the magnitude of house price gains last year, suggesting that housing market supply has generally been responding to demand over the past decade. The US and possibly New Zealand stand as possible exceptions to the trend, suggesting that relatively scarce supply may be boosting prices even further in these markets beyond what fiscal and monetary policy would suggest. Chart II-15Countries That Have Seen A Stronger Pace Of Residential Investment… Chart II-16…Have Experienced Stronger House Price Gains   Chart II-17Is This Not Enough Supply, Or Too Much Demand? As a final point about the inclination of investors to gravitate towards supply-side arguments related to the housing market, Chart II-17 presents a simple thought experiment. The chart shows a simple housing supply-demand curve diagram, in a scenario where the demand curve for housing has shifted out more than the supply curve has (thus raising house prices). Is this a scenario in which supply is too tight? Or is it a case in which demand is too strong? In our view, the tight supply answer is reasonable in circumstances where the increase in demand is normal or otherwise sustainable. But Charts II-10-II-13 clearly showed that housing demand is being boosted by easy policy, which in the case of some countries has occurred for years: interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium, and this has occurred alongside significant household sector leveraging (Chart II-18). As such, in our view, investors should be more inclined to view the global housing market as generally being driven by demand-side rather than supply-side factors. This Is Not 2007/08 … Yet We highlighted in Chart II-2 above that the household sector debt-to-GDP ratio increased sharply last year, which has raised some questions about debt sustainability among investors. For the most part, the rise in this ratio actually reflects denominator effects (namely a sharp contraction in nominal GDP) rather than a huge surge in household debt. Chart II-19 shows BIS data for the annual growth in total household debt in developed economies was roughly stable last year, at least until Q3 (the most recent datapoint available from the BIS). Chart II-18Low Interest Rates Have Fueled Household Leveraging Chart II-19Total Credit Growth Has Been Stable, But Mortgage Credit Growth Is Accelerating Chart II-20US Mortgage Growth Is Picking Up, As Repayments Slow Consumer Credit Growth But Chart II-19 shows the recent trend in total household debt, which masks diverging mortgage and non-mortgage debt trends. In the US, euro area, Canada, and Sweden, household mortgage debt has accelerated to varying degrees, underscoring that households have likely paid down non-mortgage debt with some of the savings that they have accumulated from a significant reduction in spending on services. Chart II-20 shows this effect directly in the case of the US; mortgage debt growth accelerated by roughly 1.5 percentage points in the second half of the year, whereas consumer credit growth (made up of student loans, auto loans, credit cards, and other revolving credit) decelerated significantly. This aligns with data showing that US households have used some of their savings windfall to pay down their credit card balances. This changing mix within household debt - less higher-interest-rate consumer credit, more lower-interest-rate collateralized mortgage debt – could, on the margin, help mitigate financial stability risks from the housing boom by moderating overall debt service burdens. The starting point for the latter matters, though, in accurately assessing the risks from rising house prices and increased mortgage debt, particularly in countries where household debt levels are already high. According to data from the BIS, the US already has one of the lowest household debt service ratios (7.6%) among the developed economies (Chart II-21).6 This compares favorably to the double-digit debt service ratios in the “higher-risk” countries like Canada (12.6%), Sweden (12.1%) and Norway (16.2%). On top of that, US commercial banks have become far more prudent with mortgage loan underwriting standards since the 2008 financial crisis. The New York Fed’s Household Debt and Credit report shows that an increasing majority of mortgage lending made by US banks since the 2008 crisis has been to those with very high FICO credit scores (Chart II-22). This is in sharp contrast to the steady lending to “subprime” borrowers with poor credit scores that preceded the 2008 financial crisis. The median FICO score for new mortgage originations as of Q1 2021 was 788, compared to 707 in Q4 2006 at the peak of the mid-2000s US housing boom. Chart II-21Diverging Trends In Global Household Debt Servicing Costs Chart II-22US Banks Have Become More Prudent With Mortgage Lending   US bank balance sheets are also now less directly exposed to a fall in housing values. Residential loans now represent only 10% of the assets on US bank balance sheets, compared to 20% at the peak of the last housing bubble (Chart II-23). This puts the US in the “lower-risk” group of countries in Europe, the UK and Japan where mortgages are less than 20% of bank balance sheets. This compares favorably to the “higher risk” group of countries where residential loans are a far larger share of bank assets (Chart II-24), like Canada (32%), New Zealand (49%), Sweden (45%) and Australia (40%). Chart II-23Banks Have Limited Direct Exposure To Housing Here Chart II-24Banks Are Far More Exposed To Housing Here   Like nature, however, the financial ecosystem abhors a vacuum. “Non-bank” mortgage lenders have filled the void from traditional US banks reducing their lending to lower-quality borrowers, and they now represent around two-thirds of all US mortgage origination, a big leap from the 20% origination share in 2007. Non-bank lenders have also taken on growing shares of new mortgage origination in other countries like the UK, Canada and Australia. Chart II-25Global Banks Can Withstand A Housing Shock Non-bank lenders do not take deposits and typically fund themselves via shorter-term borrowings, which raises the potential for future instability if credit markets seize up. These lenders also, on average, service mortgages with a higher probability of default, so they are exposed to greater credit losses when house prices decline. However, the risk of a full-blown 2008-style commercial banking crisis, with individual depositors’ funds at risk from a bank failure, are reduced with a greater share of riskier mortgage lending conducted by non-bank entities. This is especially true with global commercial banks far better capitalized today, with double-digit Tier 1 capital ratios (Chart II-25), thanks to regulatory changes made after the Global Financial Crisis. Net-net, we conclude that the overall financial stability implications of the current surge in house prices in the developed economies are relatively modest on average. The acceleration in mortgage growth has occurred alongside reductions in non-mortgage growth, at a time when banks are better able to withstand a shock from any sustained future downturn in house prices. However, if house prices continue to accelerate and new homebuyers are forced to take on ever increasing amounts of mortgage debt, financial stability issues could intensify in some countries. Services spending will recover in a vaccinated post-COVID world, as economies reopen and consumer confidence improves, which will likely end the trend of falling non-residential consumer debt offsetting rising mortgage debt in countries like the US and Canada. Overall levels of household debt could begin to rise again relative to incomes, building up future financial stability risks when central banks begin to normalize pandemic-related monetary policies – a process that has already started in some countries because of the housing boom. The Monetary Policy Implications Of Surging House Prices Rapidly appreciating house prices are becoming an area of concern for policymakers in countries like Canada and New Zealand, where the affordability of housing is becoming a political, as well as an economic, issue. In the case of New Zealand, the government has actually altered the remit of the Reserve Bank of New Zealand (RBNZ) to more explicitly factor in the impact of monetary policy on housing costs. The Bank of Canada announced in April that it would taper its pace of government debt purchases and signaled that its decision was based, at least in small part, on signs of speculative behavior in Canada’s housing market. Macroprudential measures like limiting loan-to-value ratios of new mortgage loans are a policy option that governments in those countries have already implemented to try and cool off housing demand. Yet while such measures can help alleviate demand-supply mismatches in certain cities and regions, the efficacy of such measures in sustainably slowing the ascent of house prices on a national scale is unclear. In the April 2021 IMF Global Financial Stability Report, researchers estimated that, for a broad group of countries, the implementation of a new macro-prudential measure designed to cool loan demand reduced national household debt/GDP ratios by a mere one percentage point, on average, over a period encompassing four years.7 If macroprudential measures are that ineffective in sustainably reducing demand for mortgage loans, then the burden of slowing house price appreciation will have to fall on the more blunt instruments of monetary policy. Importantly, surging house price inflation is not likely to give a boost to realized inflation measures – an important issue given the current backdrop of rapidly rising realized inflation rates in many countries. Housing costs do represent a significant portion of consumer price indices in many developed countries, ranging from 19% in New Zealand to 33% in the US (Chart II-26), with the euro area being the outlier with housing having a mere 2% weighting in the headline inflation index. Chart II-26A Limited Impact On Actual Inflation From Housing Yet those so-called “housing” categories overwhelmingly measure only housing rental costs and not actual house prices. This is an important distinction because rents – which are often imputed measures like in the US and not even actual rental costs - are rising at a far slower pace than actual house prices in most countries, so the housing contribution to realized inflation is relatively modest. So the good news is that booming house prices will not worsen the acceleration of realized global inflation that has concerned investors and policymakers in 2021. Yet that does not mean that central bankers will not be forced to tighten policy to cool off red-hot housing demand that is clearly being fueled by persistently negative real interest rates. In Chart II-27 and Chart II-28, we show both nominal and real policy interest rates for the “lower risk” and “higher risk” country groupings that we described earlier. The real policy rates are nominal policy rates versus realized headline CPI inflation. The dotted lines in the charts represent the future path of rates discounted by markets. Specifically, the projection for nominal rates is taken from overnight index swap (OIS) forward curves, while the projection for real rates is calculated by subtracting the discounted path of inflation expectations extracted from CPI swap forwards. Chart II-27Markets Discounting Negative Real Rates For The Next Decade Chart II-28Negative Real Rates Are Unsustainable During A Housing Bubble   There are two key takeaways from these charts: Real policy interest rates are at or very close to the most deeply negative levels seen since the 2008 financial crisis. Markets are discounting that real rates will be at or below 0% for most of the next decade. Admittedly, there is room for debate over what the equilibrium level of real interest rates (a.k.a. “r-star”) should be in the coming years. However, we deem it a major stretch to believe that real rates need to be persistently low or negative for the next ten years to support even trend growth across the developed economies. In our view, the current boom in housing demand and mortgage borrowing provides clear evidence that negative real rates are below equilibrium and, thus, are stimulating credit demand. Thus, the only way for a central bank to cool off housing demand will be to raise both nominal and, more importantly, real interest rates. Canada and New Zealand will be the “canaries in the coal mine” among developed market central banks for such a move. According to the latest Bank of Canada Financial Stability Review, nearly 22% of Canadian mortgages are highly levered, with a loan-to-value ratio greater than 450%, a greater share of such mortgages than during the 2016/17 housing boom (Chart II-29). Canadian house prices have risen to such an extent that home prices in major cities like Toronto, Vancouver and Montreal are among the most expensive in North America.8  Stunningly, a recent Bloomberg Nanos opinion poll revealed that nearly 50% of Canadians would support Bank of Canada rate hikes to cool off the red-hot housing market (Chart II-30). The central bank will be unable to resist the pressure to use monetary policy to slam on the brakes of the housing market – investors should expect more tapering and, eventually, rate hikes from the Bank of Canada over at least the next couple of years. Chart II-29Canadians Are Leveraging Up To Buy Expensive Homes Chart II-3050% Of Canadians Want A Rate Hike To Cool Housing   In New Zealand, worsening housing affordability has reached a point where a 20% down payment on the median national house price is equal to 223% of median disposable income (Chart II-31). This is forcing more first-time home buyers to take on levels of mortgage debt that the RBNZ deems highly risky (top panel). Like the Bank of Canada, the RBNZ will prove to be one of the most hawkish central banks in the developed world over the next couple of years as the central bank follows their newly-revised remit to try and cool off housing demand in New Zealand. Who is next? Housing values, measured by the ratio of median national house prices to median national household incomes, are rising in the US and UK but are still below the peaks of the mid-2000s housing bubble (Chart II-32). Meanwhile, housing is becoming more expensive across the euro area, but not in a consistent manner, with valuations in Germany and Spain having increased far more than in France or Italy. Housing valuations have actually improved in Australia over the past couple of years on a price-to-income basis. The most likely candidates for a housing-related hawkish turn are in Scandinavia, with housing valuations in Sweden and Norway closing in on Canada/New Zealand levels. Chart II-31New Zealand Housing Is Wildly Unaffordable Chart II-32Global House Price/Income Ratios Are Trending Higher   Investment Conclusions The current acceleration in global house prices is an inevitable outcome of the extraordinary monetary and fiscal easing implemented during the pandemic. Higher realized inflation is pushing real rates deeper into negative territory in many countries, fueling the demand for housing. Central banks in countries with more stretched housing valuations will be forced to turn more hawkish sooner than expected, leading to tapering and, eventually, rate hikes to cool housing demand. This has negative implications for government bond markets in countries where housing is more expensive and real yields remain too low, like Canada, New Zealand and Sweden (Chart II-33). Investors should limit exposure to government bonds in those markets over the next 6-12 months. Chart II-33Negative Real Yields & Expensive Housing Valuations – An Unsustainable Mix Bond markets in countries where house prices are not rising rapidly enough to force policymakers to turn more hawkish more quickly – like core Europe, Australia and even Japan - are likely to be relative outperformers. The US and UK are “cuspy” bond markets, as housing valuations are becoming more expensive in those two countries but the Fed and Bank of England are not facing the same domestic political pressure to use monetary policy tools to fight the growing unaffordability of housing. That could change, though, if overall household leverage begins to rise alongside house price inflation as the US and UK economies emerge from the pandemic. Current pricing in OIS curves shows that markets expect the RBNZ and Bank of Canada to begin hiking rates in May 2022 and September 2022, respectively (Table II-1). This is well ahead of expectations for “liftoff” from other developed markets central banks, including the Fed in April 2023. The cumulative amount of rate hikes following liftoff to the end of 2024 is highest in Canada, New Zealand, the US and Australia. Those are also countries with currencies that are trading at or above the purchasing power parity levels derived from our currency strategists’ valuation models. This highlights the difficult choice that central bankers facing housing bubbles must confront, as the rate hikes that will help cool off housing demand will lead to currency appreciation that could impact other parts of their economies like exports and manufacturing. Table II-1Hawkish Central Banks Must Live With Currency Strength Tracking the second-round economic consequences of eventual monetary policy actions to control excessive house price inflation, particularly in “higher risk” countries, is likely to be the subject of future Bank Credit Analyst / Global Fixed Income Strategy reports. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Robert Robis, CFA Chief Fixed Income Strategist III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields since last August. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, there has been a modest tick up in global ex-US equity performance, led by European stocks. EM stocks had previously dragged down global ex-US performance, and they continue to languish. Japanese stocks have cratered in relative terms since the beginning of the year, seemingly driven by service sector underperformance resulting from a surge in COVID-19 cases since the beginning of March. While Japanese equity performance may stage a reversal over the coming 3 months as cases counts decline and progress continues on the vaccination front, we expect global ex-US performance to continue to be led by European stocks. The US 10-Year Treasury yield has traded sideways since mid-March, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon if employment growth in Q3/Q4 implies a faster return to maximum employment than currently projected by the Fed. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, have screamed higher over the past several months. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are extremely technically stretched and sentiment is very bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 The New York Times “Texas, Indiana and Oklahoma join states cutting off pandemic unemployment benefits,” May 18, 2021. 2 The Wall Street Journal, “Shipments Delayed: Ocean Carrier Shipping Times Surge in Supply-Chain Crunch,” May 18, 2021 3 Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 4 To eliminate the pandemic base effect for both series, we adjust the year-over-year growth rates in March and April of this year by comparing them to March and April 2019. 5 Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com 6 Importantly, the BIS debt service ratios include the payment of both principal and interest, thus making it a true measure of debt service costs that includes repayment of borrowed funds – a critical issue in countries with high loan-to-value ratios for home mortgages. 7 Please see page 46 of Chapter 2 of the April 2021 IMF Global Financial Stability Report, which can be found here: https://www.imf.org/en/Publications/GFSR/Issues/2021/04/06/global-finan… 8 “Vancouver, Toronto and Hamilton are the least affordable cities in North America: report”, CBC News, May 20, 2021

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

Highlights The US is only one deflationary shock away from a European level of bond yields. On a multi-year horizon, a deflationary shock is a near-certainty. The shock will be deflationary, because even if it starts inflationary, it will quickly morph into deflationary. The reason is that the sharp backup in bond yields resulting from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. Hence, the US 30-year bond will ultimately deliver an absolute return approaching 100 percent, in absolute terms… …and relative to core European and Japanese bonds. Fractal trade shortlist: Stocks to consolidate versus bonds; Commodities look dangerously frothy; Buy USD/CAD. Feature Chart of The WeekThe Structural Level Of Bond Yields Depends On The Number Of Lasting Deflationary Shocks Ten years ago, 30-year bond yields in the US, UK and Germany stood at near-identical levels, around 3 percent. Today though, those yields are widely dispersed: the US at 2.3 percent, the UK at 1.3 percent, and Germany at 0.3 percent. What happened? In 2012, the German bond yield decoupled from the UK and the US, because the deflationary shock from the euro debt crisis was focussed in the euro area. Then, in 2016, the UK bond yield decoupled from the US, because the deflationary shock from Brexit was focussed in the UK and EU27 (Chart Of The Week). The ‘Shock Theory’ Of Bond Yields Welcome to a new concept – the ‘shock theory’ of bond yields. According to this theory, the structural level of high-quality government bond yields is simply a function of the number of lasting deflationary shocks that the economy has suffered. Each successive deflationary shock takes the bond yield to a lower structural level until it can go no lower (Chart I-2). Chart I-2Each Successive Deflationary Shock Takes The Bond Yield To A Lower Structural Level, Until It Can Go No Lower Since 2011, US, UK and German bond yields have decoupled because the US has suffered the legacies of one fewer deflationary shock than the UK, and two fewer deflationary shocks than Germany. But the important corollary is that the US is only one deflationary shock away from a European level of bond yields. When that deflationary shock arrives and the US 30-year bond yield reaches the recent low achieved in the UK, it will equate to a price gain of over 50 percent. And if the yield reaches the recent low achieved in Germany, it will equate to a price gain of well over 100 percent. Many people say that such gains are impossible. Yet ten years ago these same people were saying that UK and German long-duration bonds could never reach near-zero yields, and look what happened! Our high-conviction view is that the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. The simple reason is that another deflationary shock is just a matter of time away. Long-Term Investors Must Always Plan For A Shock Most strategists and investors claim that shocks, such as the pandemic, are inherently unpredictable, and therefore that you cannot plan for them. We disagree. Yes, the timing and nature of individual shocks are inherently unpredictable. But as we explained in How To Predict Shocks, the statistical distribution of shocks is highly predictable. What constitutes a shock? There is no established definition, so our definition is any event that causes the long-duration bond price in a major economy to rally or slump by at least 25 percent.1 (Chart I-3) Using this definition through the last 50 years, we can say that the statistical distribution of the number of shocks in any ten-year period is Poisson (3.33) and the statistical distribution of the time between shocks is Exponential (3.33). Chart I-3A Shock Is A 25 Percent Move In The Long Duration Bond Price, And A Shock Tends To Come Every 3 Years It follows that in any ten-year period, the likelihood of suffering a shock is a near-certain 96 percent (Chart I-4). And even in any five-year period, the likelihood of a shock is an extremely high 81 percent. Chart I-4On A Multi-Year Horizon, A Shock Is A Near-Certainty For many people, this creates a cognitive dissonance. Even though a shock is a near-certainty, they cannot visualise its exact nature or timing, so they resist planning for it. Yet long-term investors must always plan for shocks. Not to do so is unforgiveable. An Inflationary Shock Will Quickly Morph Into A Deflationary Shock The crucial question is, will the next shock be deflationary, or inflationary? Our high-conviction view is that it will be net deflationary. Meaning that even if the shock starts as inflationary, it will quickly morph into deflationary. The simple reason is that the sharp backup in bond yields that would come from an inflationary shock would undermine the value of $300 trillion worth of global real estate, and thereby unleash a massive deflationary impulse. The 2010s housing boom was unprecedented in its penetration and regional breadth, simultaneously encompassing cities, suburbs, and rural areas across North America, Europe, Asia and Australasia. As prices doubled almost everywhere, the value of global real estate surged by $150 trillion (Chart I-5), of which $75 trillion was due to the valuation uplift from lower bond yields (Chart I-6). To put this into context, lower bond yields have boosted the value of global real estate by the equivalent of world GDP! Chart I-5In The 2010s Housing Boom, The Value Of Global Real Estate Surged By $150 Trillion… Chart I-6…Of Which $75 Trillion Was Due To Lower Bond Yields Many people believe that real assets, such as real estate and equities, perform well in an inflationary shock, but this is a misunderstanding. Granted, the income generated by real assets should keep pace with nominal GDP. But the valuation paid for that income will collapse if it starts off at an elevated level, such as now. The starting valuation needed to generate a given real return during an inflationary shock is much lower than during price stability. For example, for equities in the low-inflation 1990s and 2000s, a starting price to earnings multiple of 15 consistently generated a prospective 10-year real return of 10 percent. But in the inflation shock of the 1970s, the same starting multiple of 15 generated a real return of zero. To generate a real return of 10 percent, the starting multiple had to halve to 7 (Chart I-7). Chart I-7In The 1970s Inflationary Shock, Valuations Collapsed How much can bond yields rise before undermining the value of global real estate? Over the past decade the global rental yield has not been able to deviate from the global long-duration bond yield by more than 100 bps.2 Given that the bond yield is already around 25 bps above the rental yield, we deduce that the long-duration bond yield can rise by no more than 75 bps before global real estate prices start getting hurt (Chart I-8).  Chart I-8The Bond Yield Can Rise By No More Than 75 Bps Before Global Real Estate Prices Get Hurt To repeat our key structural recommendation, the long-duration US bond will ultimately deliver a stellar absolute return, and a stellar relative return versus core European and Japanese bonds. Candidates For Countertrend Reversal This week we note that the rally in stocks versus bonds (MSCI All Country World versus 30-year T-bond) is likely to consolidate in the coming months – given the fragility in the 260-day fractal structure similar to previous turning points in 2008, 2010, 2013, and 2020 (Chart I-9). Chart I-9The Rally In Stocks Versus Bonds Is Likely To Consolidate In The Coming Months We also repeat our warning to steer clear of commodities. The rally in all commodities is becoming dangerously frothy, displaying the extremes of fractal fragility seen in 2008. (Chart I-10and Chart I-11). Chart I-10The Rally In Commodities Is Becoming Dangerously Frothy... Chart I-11...Displaying The Extremes Of Fractal Fragility Seen In 2008 A good trade right now is to short the Canadian dollar. Based on the loonie’s composite fractal structure, a lot of good news is already priced in, including the dangerously frothy commodity markets and the Bank of Canada’s (hawkish) taper of asset purchases. As such we expect the Canadian dollar to reverse in the coming months (Chart I-12). Chart I-12Short The Canadian Dollar Go long USD/CAD, setting a profit-target and symmetrical stop-loss at 3.7 percent. Dhaval Joshi Chief Strategist Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 25 percent. 2 Here, the global long-duration bond yield is defined as the average of the 30-year yields in the US and China. 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 - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area     Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed     Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations     Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

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

Special Report

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

Highlights After staging a tentative rebound in the first three months of the year, the US dollar has resumed its weakening trend. We expect the greenback to drift lower over the next 12 months, as global growth momentum rotates from the US to the rest of the world, the Fed maintains its ultra-accommodative monetary stance, and the US struggles to finance its burgeoning trade deficit. China will provide adequate fiscal and monetary support for its economy, which will buoy commodity prices, the yuan, and other EM currencies. The Canadian dollar should strengthen as the Bank of Canada continues to shrink its balance sheet with the goal of lifting rates by the end of 2022. EUR/USD is on track to rise to 1.25 by year-end. The pound will strengthen against the euro. While the yen’s defensive nature will limit any gains in the currency, a cheap valuation and relatively high Japanese real rates will keep downside risks in check. Global Growth Momentum To Rotate From The US To The Rest Of The World Sizable upward revisions to US growth projections gave the US dollar a modest boost in the first quarter of 2021 (Chart 1). According to Bloomberg consensus estimates, US real GDP grew by 5.4% in the first quarter, spurred on by massive fiscal stimulus and a speedy vaccination rollout. In contrast, real GDP in the euro area, the UK, and Japan contracted (Table 1). Chart 1A Dovish Fed Kept The Dollar From Strengthening Much This Year Despite Strong US Growth Vis-À-Vis The Rest Of The World Table 1Growth In Major Advanced Countries Is Expected To Start Catching Up To The US Later This Year While economic momentum still favors the US in the second quarter, the gap with other countries will narrow dramatically. The US economy is on track to expand by 8.1% in the current quarter. Bloomberg consensus expects the euro area to grow by 7.4%, the UK by 17.4%, and Japan by 4.7%. Looking out to the third quarter, both the euro area and the UK are poised to grow faster than the US. Continental Europe, in particular, should see much stronger growth in the second half of 2021 following a sluggish start to the vaccine rollout. Enough Vaccines For All? The vaccination campaign has gotten off to a slow start in most emerging markets. The spread of more contagious Covid-19 variants has led to a surge in infections in some regions. Notably, India is reporting over 300,000 new cases a day. Matters should improve on the pandemic front for many developing economies later this year. Assuming that vaccine makers are able to achieve their production targets, the Duke University Global Health Innovation Center estimates that 12 billion vaccine doses will be produced in 2021. This would be enough to vaccinate 75% of the world’s population, close to most measures of “herd immunity.” China Will Maintain Ample Policy Support Chart 2Real Rate Differentials Moved In Favor Of The Dollar At The Long End Of The Curve In Q1, But Not At The Short End Investor concerns that the Chinese authorities are about to reverse stimulus measures are overblown. Jing Sima, BCA’s chief China strategist, expects the general government budget deficit to average 8% of GDP in 2021, largely unchanged from 2020 levels. She sees credit growth falling from 15% in 2020 to 12% this year (in line with her estimate of nominal GDP growth). Given that China’s debt-to-GDP ratio stands at 270%, credit growth of 12% would leave the outstanding stock of credit roughly 33 trillion yuan (32% of GDP) higher at the end of 2021 compared to end-2020. That is a lot of new credit formation, all of which should buoy commodity prices, the yuan, and other EM currencies. Rate Differentials Remain Dollar Bearish Despite strong US growth, US 2-year real rates have continued to decline in relation to rates abroad. Long-term yield differentials did rise in favor of the US in the first three months of the year, giving the dollar a lift. However, long-term differentials have since reversed course, which helps account for the dollar’s renewed weakness (Chart 2). The Fed’s dovish stance explains why stronger growth has given so little support to the dollar. The 10-year Treasury yield generally tracks the expected Fed funds rate two-to-three years out (Chart 3). At present, the markets are as hawkish relative to the median Fed dot as they have ever been (Chart 4). Chart 3Bond Yields Are Unlikely To Rise Much Unless The Market Lifts Its Estimate Of Where The Fed Funds Rate Will Be 2-To-3 Years Out Chart 4The Market Is Very Hawkish Relative To The Fed Dots This doesn’t mean that market expectations cannot get more hawkish from here. However, for this to happen, the Fed would need to start aggressively talking up the prospect of tapering asset purchases and accelerating the timeline to hiking rates. This does not seem probable to us. Chart 5Prime-Age Employment Remains Well Below Pre-Pandemic Levels The prime-age employment-to-population ratio is still 3.7 percentage points below pre-pandemic levels (Chart 5). Overall US employment is about 5% below where it was in January 2020. Among workers earning less than $20 per hour, employment is down more than 10% (Chart 6). While some firms have complained about a shortage of workers, this likely reflects the combination of generous unemployment benefits (which expire in September) and lingering fears about catching the virus from work (which will abate as more people are vaccinated). Just as was the case following the Great Recession – when market commentary was rife with talk about a permanent increase in “structural unemployment” – concerns that the pandemic has led to lasting labor market damage will prove to be largely unfounded.   Chart 6US Employment Still Down About 5% From Its Pre-Pandemic Levels   The Dollar Faces Balance Of Payments Pressures The dollar is not a cheap currency. It is 13% overvalued based on Purchasing Power Parity exchange rates (Chart 7). One of the consequences of the dollar’s overvaluation has been a persistent trade deficit. As Chart 8 shows, the US trade deficit in goods and services has widened sharply since early 2020. Chart 7The Dollar Is Expensive Based On Its PPP Fair Value Chart 8The Widening US Trade Deficit Excessively large budget deficits drain national savings, leading to a larger current account deficit. Hence, the dollar has usually weakened whenever the government has eased fiscal policy beyond what was necessary to close the output gap (Chart 9). Foreigners have been net sellers of Treasurys this year. To a large extent, equity inflows have supported the dollar (Chart 10). However, if growth rotates from the US to the rest of the world, non-US stock markets are likely to outperform. This could cause foreign equity inflows into the US to turn into outflows. The dollar would then need to weaken to make US stocks more attractive in foreign-currency terms. Chart 9The Dollar Usually Weakens Whenever The Government Eases Fiscal Policy Beyond What Is Necessary To Close The Output Gap Chart 10Equity Inflows Supported The Dollar This Year   Technicals Point To A Weaker Dollar For many investment decisions, being a contrarian is a smart strategy. This does not apply to trading the US dollar, however. The dollar is a high momentum currency (Chart 11). When it comes to the dollar, you want to be a trend follower. Chart 11The Dollar Is A High Momentum Currency   Chart 12 shows that a simple trading rule that bought the dollar index when it was trading above its moving average would have made money, whereas a rule that bought the index when it was below its moving average would have lost money. While trading rules using short-term moving averages work best, even long-term moving average rules yield profitable results. Chart 12ATrading The Dollar: Follow Momentum (I) Chart 12BTrading The Dollar: Follow Momentum (II)   Today, the dollar is trading below all of its various moving averages, which points to further downside for the currency. The dollar’s momentum status extends to sentiment. In general, the dollar is more likely to strengthen when sentiment is already bullish. On the flipside, the dollar is more likely to weaken when sentiment is bearish. At present, dollar sentiment is bearish, which increases the odds of further dollar weakness (Chart 13). Chart 13ABeing A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Chart 13BBeing A Contrarian Doesn't Pay When It Comes To Trading The Dollar (II)   Chart 14Seasonality In The FX, Bond, And Equity Markets Finally, the dollar has tended to exhibit seasonal fluctuations. In general, the greenback has strengthened in the first half of the year and weakened in the second half (Chart 14). It is not entirely clear what explains this phenomenon, but it is worth noting that since 1985, almost all of the cumulative decline in Treasury yields has occurred in the back half of the year. Cyclical Currencies Are Most Likely To Strengthen Against The US Dollar Cyclical (i.e., high-beta) currencies will fare best against the US dollar over the next 12 months. In the EM space, strong global growth will benefit the Mexican peso, Chilean peso, Brazilian real, South African rand, Korean won, and the Indonesian rupiah. In the developed economy sphere, the Swedish krona, Norwegian krone, and Australian and Canadian dollars are poised to appreciate the most. We are particularly bullish on the loonie. The Bank of Canada announced on Wednesday that it will reduce the weekly pace of government bond purchases from C$4 billion to C$3 billion. Even before this announcement, the BoC’s balance sheet was shrinking following the decision to scale back repo operations and discontinue several other asset purchase programs. The BoC also indicated that it expects the Canadian economy to return to full employment in the second half of 2022, which should set the stage for the first rate hike by the end of next year. We expect EUR/USD to reach 1.25 by year-end. The British pound will strengthen to 1.50 against the dollar and 1.20 against the euro. Chart 15 shows that GBP/USD has closely tracked the rise and fall of global equities. Notably, the pound is 15% undervalued against the euro based on real 2-year interest rate differentials (Chart 16). Chart 15GBP/USD Has Closely Tracked Global Equities Chart 16The Pound Is Undervalued Against The Euro Based On Real Short-Term Interest Rate Differentials   The Japanese yen is a highly defensive currency. Hence, stronger global growth will pose a headwind to the yen. Nevertheless, the yen is quite cheap, trading at a 20% discount to its Purchasing Power Parity exchange rate (Chart 17). Moreover, real yields are higher in Japan than they are in the other major economies, reflecting ongoing deflationary pressures (Chart 18). On balance, we expect the yen to move sideways against the US dollar over the next 12 months. Chart 17The Yen Is Quite Cheap Chart 18Real Yields Are Higher In Japan Than In The Other Major Economies   Equity Implications Of A Weaker Dollar Cyclical stocks tend to outperform defensives when the dollar is weakening. To the extent that cyclicals are overrepresented in stock market indices outside the US, a weaker dollar favors non-US equities (Chart 19). Chart 19Cyclical Stocks Tend To Outperform Defensives When The Dollar Is Weakening Chart 20Value Stocks Generally Do Best In A Weak Dollar Environment Value stocks also tend to do best in a weak dollar environment (Chart 20). As such, we recommend that investors overweight cyclicals, non-US, and value stocks over the next 12 months.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores