Global

Special Report

Highlights The miserable performance of commodities as an asset class post-GFC (since 2010) has disincentivized investment in oil and metals, which means growth in supply will lag demand going forward (Chart of the Week). Energy: Bullish. OPEC 2.0’s massive spare capacity supports its production-management strategy, and will keep crude-oil forward curves in backwardation. Base Metals: Bullish. With supply growth flat to negative year-on-year (y/y), copper and aluminium will post physical deficits as demand ex-China recovers. This will keep their forward curves backwardated as well. Precious Metals: Bullish. We expect the Fed’s ultra-accommodative policy to keep US real rates low, and return the USD to a bear market. This will be bullish for gold. Ags/Softs: Neutral. Ag markets remain balanced, punctuated by periodic weather-related rallies. A weaker USD also will be bullish for grains. In line with our expectation for stronger prices, continued backwardation in industrial commodities and a weaker USD, we are getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT) at tonight’s close. This will broaden our exposure to commodities as an asset class. Risks due to COVID-19 persistence and a higher USD demand remain. The balance of risk, however, is to the upside. Feature Commodities as an asset class performed miserably post-Global Financial Crisis (GFC), as the Chart of the Week demonstrates. Partly this is due to the erratic-but-ultimately-accommodative monetary policies globally coming out of the GFC, which went into hyperdrive during the COVID-19 pandemic and supercharged demand for financial assets. During this period, industrial commodities suffered from periodic surpluses resulting from overproduction set off by high prices at the beginning of the 2000s when China set off a global commodity super-cycle. In the post-GFC world, producers brought commodities to market almost oblivious to the state of demand. This over-investment on the supply side led to market-share wars in oil and bulks like iron ore, which were ruinous to producers. Endogenous factors were not the only source of under-performance for commodities post-GFC. Stop-and-go fiscal stimulus in EM markets, which made base metals demand difficult to forecast; massive crop harvests and carry-over stocks year after year; highly erratic trade policy that distorted the flow of ags and manufactured products with out-of-the-blue tariffs, and a once-in-a-century pandemic that wiped out ~ 10% of global oil demand, all contributed to weak and volatile market conditions. Chart of the WeekCommodities As An Asset Class Performed Miserably Post-GFC Commodity producers, too, incentivized investors to seek greener pastures over this period, owing to their inability to earn returns in excess of their cost of capital, let alone anything even close to the returns available in the tech-heavy growth sector of equities markets. Producers’ difficulties have been compounded by the growing importance of ESG investing (Environmental, Social, and Governance), which, over time will increase the cost of producing commodities compliant with consumers’ and investors’ stated preferences for sustainable and equitable business practices. Investors, as is their wont, made it perfectly clear they have no interest investing in firms that cannot produce commodities profitably in line with ESG goals. There are too many opportunities elsewhere to invest in firms that can deliver goods and services profitably, regardless of how important commodities might be to the global economy. Industrial commodity markets, particularly oil and metals, now are under-resourced on the supply side, just as demand ex-China recovers in the wake of massive fiscal and monetary stimulus – with more on the way in the US. The Return Of Commodity-Index Investing For investors in long-only commodity-index instruments that provided a source of uncorrelated returns at the turn of the 21st century, the post-GFC period was long and painful. However, the balance of risks in these instruments – given the underlying fundamentals in the largest sectors of the asset class – is decidedly to the upside. Returns from long-only commodity indexes are derived from price appreciation of the index, so-called roll-yields, and the return on collateral used to post margin to support futures and exchange-cleared swaps comprising the index.1 In the industrial commodities, price gains have come from tightening markets – i.e., demand levels exceed supply levels, pushing prices higher. In oil, OPEC 2.0’s production-management strategy has been remarkably successful in reducing the supply overhang that has plagued markets on and off for the entire post-GFC period (Chart 2). Chart 2Oil Demand Will Exceed Supply Per OPEC 2.0 Strategy On the metals side, production growth has flattened in copper (Chart 3) and aluminum (Chart 4) as demand ex-China starts to recover. We expect physical deficits this year and next. Chart 3Copper's Physical Deficits Will Keep Futures Bacwardated Chart 4Flat To Backwardated Aluminum Forwards Expected In the case of copper, this will extend a two-year stretch of zero supply growth that has forced inventories to draw globally. Prices have rallied sharply on the back of these deficits, but will have to be sustained at these levels – and go higher – to spark investment in new supply necessary to support a revival of global economic growth; the buildout of renewable generation and new grids, and consumer-driven electric vehicles (EVs) demand. The only market that we are not bullish on due to tightening fundamentals is ags. While global grain and soybean inventories are falling (Chart 5), it’s a mixed picture. Global bean stocks are down (Chart 6), as are corn stocks (Chart 7). Wheat stocks are moving higher (Chart 8), while rice stocks remain roughly flat y/y (Chart 9). Chart 5Global Grain Balances Tightening Slightly Chart 6Global Bean Stocks Are Falling... Chart 7...As Are Corn's Fundamentals Chart 8Global Wheat Stocks Are Rising... Chart 9...While Rice Stocks Remain Balances Roll Yields From Industrial Commodities In addition to supply-demand fundamentals being supportive of industrial commodities’ price levels, we continue to expect a weakening of the USD, which will provide a strong tailwind to commodity price levels particularly gold, which we model primarily as a function of financial variables including the dollar and US real rates (Chart 10). A weaker USD also will be supportive of oil price levels, which have been in a long-term equilibrium with the dollar since 2000, when oil became a random-walking commodity (Chart 11).2 Metals also will get a lift from a weaker USD (Chart 12), as will ags (Chart 13), which remain balanced and well-supplied. This overall support to demand from the weaker dollar will, all else equal, put pressure on inventories and force them lower. Chart 10Weaker USD Will Boost Gold... Chart 11...Provide Oil A Tailwind... Chart 12...Lift Metals... Chart 13...And Ags This is particularly important for commodity-index investing, since falling inventories lead to backwardated forward curves, which are the principal source of roll yields in long-only index products.3 For long-only commodity index investors, the periods when commodities outperformed equities were characterized by backwardated forward curves, and, typically but not always, rising prices. Of the two factors driving commodity returns, backwardation is the most persistent and long-lived. Price increases (and decreases) often result from shocks. The market responds to a shock, finds a new level, and then oscillates randomly around it. Investment Implications We believe we are entering a period that will be characterized by tighter supply-demand balances for industrial commodities. The result of this will be lower inventories for oil and base metals, which will keep price levels well bid and forward curves flat to backwardated. A weaker USD will support industrial commodities, gold and ag prices. These are ideal conditions for long-only commodity-index investors. While there are numerous vehicles available to investors to express this view, we believe a dynamic portfolio approach – which chooses exposure for individual index components based on their backwardation – is best suited to current market conditions, given that we expect these markets to be in asynchronous bull markets over the next couple of years.4 At the close of business tonight, we will be getting long the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), in order to broaden our exposure to commodities as an asset class. This index is maintained by S&P Dow Jones Indices.5 Separately, in a housekeeping note, we were stopped out of our tactical nickel position with a loss of 15.8%, following a sudden sell-off Friday. Based on reporting from forbes.com, China’s Tsingshan Holding Group took the market by surprise with its news release that it is producing “a battery-grade form of nickel from low-grade saprolite ore, a technical breakthrough which threatens to flood the nickel market.”6 We will continue to evaluate this development vis-à-vis re-entering our tactical nickel position in the near term.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Roll yield refers to the gain from a commodity spread trade. A useful way to understand this is to imagine a market in which the forward curve is flat, i.e., the prompt futures contract for delivery next month is trading at the same price as a deferred futures contract specifying delivery in the following month. Assume an investor buys the prompt contract and the holds this position until it has to be either liquidated or rolled forward and its price has gone up, while the deferred contract’s price is unchanged. The investor can sell the prompt contract and use those proceeds to buy the deferred contract, which is still trading unchanged. The investor can either buy more of the contract with the proceeds from this trade, or invest it elsewhere. The gain from this transaction is referred to as the “roll yield.” In a backwardated market – this process can be repeated (buying at a low price and selling at a higher price as the futures contract rolls up the curve and gets closer to delivery), which is an ongoing source of yield. Of course prompt prices can fall below where the deferred contract was purchased, resulting in a loss, but typically the roll yield in a backwardated market is persistent. The opposite holds for contango market, which results in negative returns for investors buying, holding, and rolling futures seeking to earn roll yields. These spread trades are the commodity markets’ analog to the curve-steepeners and curve-flatteners in fixed income markets (e.g., the 2s-10s spread in U.S. Treasuries). 2     Please see Helyette Geman, (2007), "Mean Reversion versus Random Walk in Oil and Natural Gas Prices,“ in Advances in Mathematical Finance, Birkhäuser, Boston. 3    Please see Commodities As An Asset Class V. 3.0, a Special Report we published 21 August 2014. It is available at ces.bcaresearch.com. 4    We develop this thesis in last week’s Special Report entitled Industrial Commodities Super-Cycle Or Bull Market?, which is available at ces.bcaresearch.com. 5    Please see S&P GSCI Dynamic Roll, particularly its Methodology, which was published by S&P Global in January 2021. 6    Please see Nickel Price Falls By 16% But That Might Not Help EV Makers published by forbec.com 8 March 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Closed Trades

Please note that we will be presenting a webcast on Thursday March 11 at 10:00 AM EST for the Americas and EMEA regions and on March 12 at 9:00 HKT/12:00 AEDT for APAC clients. We will be discussing macro themes and investment strategies. Highlights EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were in 2013. Yet better does not mean they will be unscathed. The combination of rising US bond yields and a firming US currency will suffocate EM risk assets in the near-term. A neutral allocation is warranted in EM stocks and credit markets within global equity and credit portfolios, respectively. Feature Ever since the US elections concluded in January with a Blue Sweep, we have been warning that rising US bond yields could trigger a setback in global markets in general, and in EM markets in particular. EM equities, currencies and fixed-income markets have recently experienced a correction (Chart 1). The question now is: Is the market rout over? Or is there more to come? We are inclined to believe that the correction is not over. Rising US Treasury yields have been the culprit of the shakeout in global growth stocks, EM equities, as well as EM currencies. Therefore, taking a stance on US bond yields and on the US dollar is critical for assessing the outlook for EM financial markets. Odds are that the selloff in US long-term bonds and the rebound in the US dollar are not yet over because: Positioning and sentiment on US long-dated Treasuries is neutral, as illustrated in Chart 2. Chart 1Rising US Real Yields Have Caused A Shakeout In EM Chart 2Investor Sentiment And Positioning In US Treasurys Are Neutral   Typically, US bond yields do not reverse their ascent until investor sentiment becomes downbeat and bond portfolios are of materially short duration. These conditions for a top in bond yields are not yet present. US government bond yields would have been much higher if it were not for the Federal Reserve and US commercial banks’ massive bond-buying spree. The Fed has bought $2.8 trillion and US commercial banks have purchased about $300 billion of Treasurys in the past 12 months (Chart 3). One of the main motives for commercial banks to buy US Treasurys has been the SLR relief initiative which commenced on April 1, 2020.1 This SLR relief is due to terminate on March 31, 2021. Unless it is extended, commercial banks will drastically curtail their net government bond purchases. This will exert upward pressure on Treasury yields. Regarding the greenback, investor sentiment remains quite bearish (Chart 4). From a contrarian perspective, this heralds further strength in the US dollar. Chart 3Surging Purchases Of US Treasurys By The Fed And Commercial Banks Chart 4Investors Are Still Bearish On The US Dollar   From a cyclical perspective, US growth will be stronger relative to its potential, and vis-à-vis other DMs, EMs and China. Growth differentials moving in favor of the US foreshadows near-term strengthening of the dollar. Structurally, the bearish case for the US currency hinges on both the Federal Reserve falling behind the inflation curve and ballooning US twin deficits. In our view, this will ultimately be the case. Hence, the long-term outlook for the US dollar remains troublesome. That said, twin deficits alone are insufficient to produce a continuous currency depreciation. The twin deficits must also be accompanied with low/falling real interest rates – in order to generate sufficient conditions for currency depreciation. As long as US real rates continue rising, the dollar’s rebound will be extended. The USD/EUR exchange rate has been correlated with the 10-year real yield differential and this relationship will persist (Chart 5).  Bottom Line: US government bonds will continue selling off. Rising bond yields (including rising real yields) will support the dollar in the near-term. The combination of rising US bond yields and a firming US currency will cause global macro volatility to rise (Chart 6). This will suffocate EM risk assets and EM currencies. Chart 5US Real Yields (TIPS) Will Continue Driving The US Dollar Chart 6Aggregate Financial Market Volatility: Higher Lows   Impact On EM: 2013 Versus Now Are we entering another Taper Tantrum episode as in the spring of 2013 when many EMs were devastated? There are both similarities and differences between the current period of rising US bond yields and the 2013 episode. Similarities: Today, as in early 2013, investor sentiment on EM is very bullish and investors are long EM (Chart 7). Chart 7Investor Sentiment On EM Stocks Was At A Record High In January In early 2013, as is the case today, EM local currency bond yields were very low and EM credit spreads were too tight. When US Treasury yields spiked in the spring of 2013, EM assets tanked. Many commentators blamed it on the Fed. We disagree with that interpretation. Remarkably, the rise in US TIPS yields in 2013 had little impact on equity indices such as the S&P 500 and Nasdaq, or on US corporate spreads (Chart 8). The correction in the US equity market lasted about a week. Yet, EM equities, fixed income markets and currencies experienced a prolonged slump, and in many cases, a bear market. There is no basis to believe that the Fed’s policy and US bond yields are more important to EM than they are to US credit and equity markets. The core rationale for the EM bear market in 2013 was poor domestic fundamentals. The Fed’s tapering was the trigger, not the cause. Differences: The key difference between the current episode and the 2013 Taper Tantrum is EM macro fundamentals. Specifically: EM economies (ex-China, Korea and Taiwan) entered 2013 with booming bank loans and strong domestic demand as well as high inflation (Chart 9). Chart 8US Markets Were Not Hit By The Taper Tantrum In 2013 Chart 9EM (ex-China, Korea And Taiwan): 2013 Vs Now Chart 10EM (ex-China, Korea And Taiwan): 2013 Vs Now Presently, EM bank credit is subdued, domestic demand is dismal, and inflation is tame. Besides, EMs (ex-China, Korea and Taiwan) had a very large trade deficits in 2013 and were financing them via foreign borrowing, which was roaring prior to 2013 (Chart 10). Presently, their trade balances are in surplus and foreign indebtedness has not increased in recent years. Bottom Line: In 2013, EM economies (ex-China, Korea and Taiwan) were overheating and were addicted to foreign funding. These were the reasons why EM currencies and fixed income markets teetered when US bond yields spiked in 2013. Presently, the majority of EM economies (ex-China, Korea and Taiwan) have different types of malaises: domestic bank loan origination is too timid, consumer spending and capital expenditures are moribund, inflation is low and fiscal policy is tight. Consequently, EMs (ex-China, Korea and Taiwan) are better positioned to handle higher US bond yields today than they were back in 2013. Yet better does not mean they will be unscathed. Investment Strategy Equities: The key variable to watch to assess the vulnerability of both US and EM equity markets is their respective corporate bond yields. Historically, rising corporate bond yields (shown inverted in both panels of Chart 11) heralds lower share prices. Chart 11Rising Corporate Bond Yields Are Bad For Share Prices Given that both EM and US corporate credit spreads are too tight, they are unlikely to narrow further to offset rising US Treasury yields. Instead, EM and US corporate bond yields are likely to rise with US Treasury yields. This will trigger more weakness in share prices. Besides, rising EM local currency government bond yields also point towards more downside in EM equities (yields are shown inverted on the chart) (Chart 12). Chart 12Rising EM Local Currency Bond Yields Heralds Weaker Equity Prices Concerning equity style, global growth stocks have peaked versus global value stocks. In the EM equity space, we have less conviction on growth versus value. As to regional allocation in a global equity portfolio, we continue recommending a neutral allocation to EM, underweighting US and overweighting Europe and Japan. Commodities: Investors’ net long positions in commodities are very elevated (Chart 13). As US bond yields rise and the US dollar continues rebounding, there will be a de-risking in the commodities space resulting in a pullback in commodities prices. Currencies: We continue shorting a basket of EM currencies – including BRL, CLP, ZAR, TRY and KRW versus the euro, CHF and JPY. Several EM currencies have failed to break above their technical resistance levels, suggesting that a pullback could be non-trivial (Chart 14). Chart 13Investors Are Record Long Commodities Chart 14Asian Currencies Hit Technical Resistances   In central Europe, we are closing the long CZK/short USD trade with a 3.8% gain. Continue holding the long CZK/short PLN and HUF position. Local fixed income markets: EM local bond yields have risen in response to rising US treasury real yields and the setback in EM currencies. This might persist in the near-term, but we continue to recommend receiving 10-year swap rates in selected countries where inflation risks are low and monetary and fiscal policies are tight. These countries include Mexico, Colombia, Russia, China, India and Malaysia. A further rise in their swap rates would represent an overshoot and hence, should not be chased. EM currencies are more vulnerable to a selloff than local rates are. We continue to wait for a better entry point in currencies to recommend buying cash domestic bonds instead of receiving swap rates. EM Credit: A neutral allocation to EM sovereign and corporate bonds is warranted in a global credit portfolio. Our sovereign credit overweights are Mexico, Russia, Malaysia, Peru, Colombia, the Philippines and Indonesia, while our sovereign credit underweights are Brazil, South Africa and Turkey. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The Supplementary Leverage Ratio (SLR) is equivalent to Basel III Tier-1 leverage ratio and varies from 3-5% for US banks. Under the relief program last April, the Fed allowed US banks to exclude holdings of US Treasury Bonds and cash kept in reserves at the Fed from their assets when calculating this ratio. The SLR relief is planned to end March 31, 2021. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The recent backup in bond yields could cause stocks to fall further in the near term. However, history suggests that as long as yields remain low in absolute terms, as they are now, equities will recover. Market angst that the Fed is about to turn more hawkish is unwarranted. Central banks around the world have both the tools and the inclination to keep bond yields from rising excessively. Despite the jump in bond yields, the forward earnings yield is 540 basis points above the real bond yield in the US. Outside the US, the forward earnings yield is 615 basis points above the real bond yield. In 2000, the earnings yield was below the real bond yield. Just as value stocks began to outperform growth stocks in mid-2000, the end of the pandemic will herald a similar period of value-oriented outperformance. Commodity producers and banks will lead the way. Some Parallels Between Today And 2000… Stock prices have buckled in recent weeks, raising concerns that global bourses are at risk of a major crash, just like they were in early 2000. There are certainly some notable similarities between 2000 and the present: In both cases, the preceding rise in stock prices was fueled by the Federal Reserve’s desire to prevent an exogenous shock from causing a major recession (Chart 1). Last year, the shock was the pandemic. In 1998, it was the collapse of Long-Term Capital Management (LTCM). The Connecticut-based hedge fund imploded shortly after Russia defaulted on its debt, leading to a gut-wrenching 22% decline in the S&P 500. The brewing crisis prompted the Fed to cut rates by a total of 75 basis points. Spurred on by fears of Y2K, the Fed also injected vast amounts of liquidity into the financial system. Tech stocks led the market higher both in the late 1990s and last year. The NASDAQ Composite rose 68% between its intra-day low in October 1998 and March 2000. In 2020, the NASDAQ outperformed the S&P 500 by 24% and returned 44% overall. Chart 1The NASDAQ's 1999 Surge Followed The 1998 “Insurance Cuts” And Coincided With The Fed’s Balance-Sheet Expansion Chart 2Low-Priced Stocks Have Been The Winners In The First Quarter The speculative mania in the 1990s spread from large-cap tech stocks to small-cap companies. We saw the same pattern earlier this year, with prices and trading volumes exploding among smaller, low-priced stocks (Chart 2). As was the case in the late 1990s, retail investors – this time armed with “stimmy” checks and access to zero-commission trading accounts – plowed into the market. Chart 3Some Pockets Of Bullish Equity Sentiment Chart 4Some Pockets Of Bullish Equity Sentiment Bullish equity investor sentiment was rampant at the peak of the stock market in 2000. Although not quite to the same extent as back then, most measures of investor sentiment turned bullish prior to the recent selloff (Chart 3). Like most investors, analysts were wildly optimistic on stocks in the late 1990s (Chart 4). Long-term earnings growth projections are very optimistic today, a potentially ominous signal given that (unlike in the late 1990s), productivity growth is now more anemic. Rising stock prices in the late 1990s allowed corporate insiders to cash in their options, while enabling new companies to go public. Recently, we have seen a flurry of companies list their shares, in some cases through dubious SPAC vehicles (Chart 5). Valuations reached nosebleed levels in 2000. While the forward P/E ratio on the S&P 500 is somewhat below its 2000 peak, other valuation measures such as price-to-sales, Tobin’s Q, and enterprise value-to-EBITDA are above where they were in 2000 (Chart 6). Chart 5Renewed Interest In Listing Stocks Chart 6Stretched Valuations, Then And Now … But One Important Difference Despite the parallels between today and 2000, there is an important difference: The Federal Reserve. Having cut rates in 1998, the Fed reversed course in mid-1999, eventually taking the fed funds rate up to 6.5% in May 2000. The yield curve inverted in February of that year, shortly after the 10-year yield reached a high of 6.79%. Chart 7What Happens To Equities When Treasury Yields Rise? Bond yields have risen briskly over the past six months. However, they remain very low in absolute terms. While rising yields can produce a temporary stock market correction, they need to move into restrictive territory in order to trigger a recession and an accompanying bear market in equities. Chart 7 highlights some research that Garry Evans and BCA’s Global Asset Allocation team recently produced. It shows eight episodes since 1990 of a sharp rise in the 10-year Treasury yield. On every occasion (except in 1993-94, when the Fed unexpectedly raised rates in February 1994), equities performed strongly while rates were rising (Table 1). Today, the forward earnings yield on the S&P 500 is 540 basis points above the real yield. In 2000, the real bond yield was higher than the earnings yield (Chart 8). The gap between earnings yields and real bond yields is even greater outside the US, where valuations are generally more attractive. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 21% in real terms for equities to underperform bonds. Many other stock markets would have to decline by more than that (Chart 9). Table 1As Long As Bond Yields Don't Rise Into Restrictive Territory, Stocks Will Recover Chart 8Relative To Bonds, Stocks Are More Favorably Valued Now Than in 2000 Chart 9Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Central Banks Will Lean Against Rising Bond Yields Stocks sold off earlier today on the perception that Jay Powell had failed to push back forcefully against the recent increase in bond yields. We think this angst is unwarranted. As Powell noted, most of the rise in bond yields reflected economic optimism. If yields were to continue rising in the absence of further economic improvements, the Fed would dial up the rhetoric, stressing its ability to buy bonds in unlimited quantities in order to support the economy. Despite all the fiscal stimulus, the unemployment rate remains elevated – perhaps as high as 10% according to some Fed measures. The prime-age employment-to-population ratio is four percentage points below where it was before the pandemic (Chart 10). Moreover, many stimulus measures will expire towards the end of the year. With the prospect of a “fiscal cliff” in 2022, we expect the Fed to want to tread carefully in withdrawing monetary support. What would really rattle investors is if long-term inflation expectations were to rise above the Fed’s comfort zone. However, considering the 5-year/5-year forward inflation breakevens are still below where they were in 2012-13, this is not an imminent risk (Chart 11). Chart 10The Fed Will Remain Accommodative To Aid The Labor Market Recovery Chart 11Inflation Expectations Have Recovered But Are Still Low Like the Fed, the ECB wants to keep financial conditions highly accommodative. On Tuesday, ECB Executive Board member Fabio Panetta, echoing comments made by other senior ECB officials, said that higher yields were “unwelcome and must be resisted.” He noted that “We are already seeing undesirable contagion from rising US yields into the euro area yield curve,” adding that the ECB “should not hesitate” to increase the pace of bond purchases. The ECB’s threat is credible. Already, its purchases have deviated significantly from its capital key, revealing Frankfurt’s willingness to act where and when it is needed. In the same spirit, the Reserve Bank of Australia boosted its government bond purchases earlier this week after the 10-year yield backed up from 0.7% last October to over 1.9% late last week. The RBA also reaffirmed its intent to maintain the current 3-year Yield Curve Control target at 0.1%, stating that “The Board will not increase the cash rate until actual inflation is sustainably within the 2-to-3 percent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. The Board does not expect these conditions to be met until 2024 at the earliest.” The RBA’s determination to keep bond yields down is noteworthy given that the neutral rate of interest is higher in Australia than in most other developed economies.1  If the RBA does not intend to raise rates for the next three years, it may take even longer for other central banks to take away the punch bowl. Will Value Stocks Begin To Outperform As They Did Starting In Mid-2000? There is another potential parallel with 2000 that is worth mentioning. This was the year that the outperformance of growth stocks came to a halt and value stocks began to shine. In fact, outside of the tech sector, the S&P 500 did not peak until May 2001 (Chart 12). Value continued to outperform right through to 2007. Since February 12th of this year, the price of the highly liquid Vanguard Growth ETF (VUG, market cap of $143 billion) has fallen by 8.9% while the price of the Vanguard Value ETF (VTV, market cap of $97 billion) has risen 0.5%. Despite the nascent outperformance of value names, they still remain relatively cheap. According to a simple valuation measure that combines price-to-earnings, price-to-book, and dividend yields, value stocks are more than three standard deviations cheap relative to growth stocks – a bigger valuation gap than seen at the height of the dotcom bubble (Chart 13). Chart 12The Non-Tech Portion Of The Stock Market Peaked More Than A Year After The Tech Bubble Burst Chart 13The Tech Bust Of 2000 Also Marked The Start Of A Multi-Year Outperformance By Value The Outlook For Commodity Stocks And Bank Shares Commodity producers are overrepresented in value indices. Strong global growth against a backdrop of tight supply should heat up the commodity complex over the next 12-to-18 months. Chart 14 shows that capital investment in the oil and gas sector has fallen by more than 50% since 2014. BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects crude oil demand to outstrip supply over the remainder of this year (Chart 15). Chart 14Oil + Gas Capex Collapses In COVID-19’s Wake Chart 15Crude Oil Demand To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Charts 16A & 16B). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, a big slug of demand in a market that consumes about 26mm tonnes per year. Chart 16ACopper Will Be In Physical Deficit... Chart 16B...As Will Aluminum Ongoing strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 17). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Chart 17China Keeps Buying More And More Commodities Chart 18Credit Growth Has Been Recovering Along with commodity producers, financials helped propel value indices during the 2000s. While credit growth is unlikely to revert to its pre-GFC days, it has been trending higher in both the US and Europe (Chart 18).   Analysts are starting to take note of improving bank earnings prospects. EPS estimates for banks are rising more quickly than for tech companies on both sides of the Atlantic (Chart 19). Not only is the “E” in the P/E ratio for banks likely to rise, the ratio itself will increase. Currently, US and European banks are trading at 14 and 10-times forward earnings, respectively, a huge discount to the broad market in general, and tech stocks in particular (Chart 20).  Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (I) Chart 19EPS Estimates For Banks Are Rising More Quickly Than For Tech Companies (II) Chart 20Banks Are Cheap   Bottom Line: Despite near-term uncertainty, investors should overweight stocks on a 12-month horizon, while pivoting away from last year’s winners (growth stocks) towards last year’s losers (value stocks).   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1  According to RBA’s estimates, the neutral rate of interest in Australia is at the high end of developed market estimates. Specifically, Australia’s R-star is higher than the average of the US and euro area R-stars and is slightly lower than the average of the Canadian and UK neutral rates. 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Special Report

Highlights We use a correlation-hedge approach to manage emerging market (EM) currency exposure for global investors with nine different home currencies. For USD-based investors, EM debt volatility is driven by the EM spot exchange rate vs. USD. Hedged EM debt has better absolute and risk-adjusted returns than US Treasurys. Investing in EM equities, on the other hand, makes sense only when the expected absolute return is positive on a sustained basis. During these episodes, hedging is not necessary. If USD-based investors choose to manage EM currency exposure directly, then a 12-month momentum-based dynamic hedging strategy could add value in terms of risk-adjusted returns for both EM stocks and bonds. USD-based investors could also diversify the source of funding by selling closely correlated DM currencies using an overlay of currency forwards. For non-USD-based investors, EM currency volatility is low and there is no need to fully hedge EM exposure. Domestic bonds have very low volatility, therefore these investors should avoid EM debt if their objective is to maximize risk-adjusted returns. To enhance returns, unhedged EM equities are a much better choice than EM debt. Currency overlay, in line with our long-held view on the total portfolio approach, should be managed at the total fund level. Feature How to manage EM currency exposure when investing in EM local currency debt and equities has been a frequently asked question since our reports on managing developed market (DM) currency exposure when investing in DM equities 1,2 and government bonds.3 According to the BIS Triennial Central Bank Survey, EM currency exchange markets have evolved rapidly since 2001. The daily turnover reached 1.65 trillion dollars in April 2019, which is about 25% of the global currency daily turnover.4 While it is becoming increasingly easy to trade EM currencies, compared with DM currencies it is still more costly and operationally more challenging to hedge EM currency exposure, especially the currencies with non-deliverable forwards (NDFs) that require collateral management. In this report, we identify the return and volatility drivers of EM local currency government bonds (represented by JP Morgan’s GBI-EM Global Diversified Local Currency Index) and EM equities (represented by MSCI’s EM Net Return Index). We briefly touch on a momentum-based dynamic hedging strategy to hedge EM exposure directly for USD-based investors. Our main focus is to test a correlation-hedge approach, both static and dynamic, for nine home currencies: the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Canadian dollar (CAD), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), and the Norwegian krone (NOK). We want to determine if a USD-based investor’s return/risk profile would be improved when investing in EM assets by using unfunded overlays of DM currency forwards. Finally, we present solutions for non-USD investors, which vary based on the correlations between the home currencies and the EM currency aggregates. Part 1: The USD Perspective 1.1 EM Asset Return Drivers In general, unhedged USD returns for US investors from investing in foreign assets can be decomposed into three parts as shown in the following equation (1): (1+Rd) = (1+Rh) (1+Rc) (1+Rs) ..…..(1) Where, Rd is the unhedged return in USD. Rh is the hedged return in USD using currency forwards. Rc is the carry return resulting from the short-term rate differential between a foreign country and the US. Rs is the spot exchange rate return of a foreign currency vs. the USD (quoted as how many USD per 1 unit of foreign currency). Chart 1A and Chart 1B show the return decompositions of JP Morgan’s (JPM) EM local currency government bonds and MSCI’s EM equities based on equation (1). Chart 1AEM Local Debt USD Return Decomposition Chart 1BEM Equities USD Return Decomposition Hedging reduces both the volatility and returns for both EM local currency bonds and equities; however, the return and volatility reductions are more significant in bonds than in stocks (panel 1 in Chart 1A and Chart 1B). EM currency aggregate indexes implied from JPM and MSCI are different because of the different country compositions. The currency component has been very volatile for both indexes and has generated negative returns during the 18 years from January 2003 to January 2021 (panel 3 in Chart 1A and Chart 1B). The carry component from JPM is sharply higher than that from MSCI, which is also the result of different country compositions (panel 2, Chart 1A and Chart 1B). The carry components from both indexes have very low volatility with positive returns over the 18-year period. Many EM countries had much higher interest rates than the US, therefore a US investor had to be exposed to EM currencies to capture this carry gain. Thus, from a return-enhancing perspective, an investor should hedge only if he/she expects the EM currency spot exchange rate to depreciate more than the implied carry (panel 3, Chart 1A and Chart 1B). The answer may be different from a volatility-reducing perspective, especially for EM debt where currency volatility dominates bond volatility. We plot the return-risk profiles of EM local currency bonds and equities (hedged and unhedged) in Charts 2A, 2B and 2C to show how they behave in different environments compared to US equities, US Treasurys and hedged non-US global government bonds. Table 1 further lists the detailed statistics of all the above-mentioned assets, in addition to the spot currency and carry components implied from JPM’s EM local currency bond index and MSCI’s EM index, ranked by risk-adjusted return. The entire 18-year period (Chart 2A) is also separated into the period with steadily rising EM currencies (1/2003 – 7/2008, Chart 2B) and the period with declining EM currencies (8/2008-1/2021, Chart 2C). Chart 2AUSD Asset Return-Risk Profile For The Entire Period (1/2003-1/2021) Chart 2BUSD Asset Return-Risk Profile When EM Currencies Were Strong (1/2003-7/2008) Chart 2CUSD Asset Return-Risk Profile When EM Currencies Were Weak (8/2008-1/2021) Both EM debt and equities had impressive unhedged returns in the period from January 2003 to July 2008 when the EM currency index rose steadily against the USD. Even on a hedged basis, EM bonds still delivered better absolute returns (5.1%) than US Treasurys (4.3%) with lower volatility. In terms of EM equities, although hedged return of 22.8% significantly outpaced US equities (9.7%), the volatility of EM equities (16.8%) was much higher than US equities (9.8%). Interestingly, in the period with declining EM FX from August 2008 to January 2021, hedged EM equities (5.6%) significantly underperformed US equities (11.5%) with comparable volatility, but hedged EM bonds (4.2%) outperformed US Treasurys (3.6%) with comparable volatility, despite the negative carry. It is easy to make the case for EM equities: US investors should not touch EM equities unless they are convinced that EM is entering a sustainably strong absolute return period. There is no need to hedge the currency exposure because the risk reduction is relatively small. In the case of EM local currency debt, the three components of total returns in USD based on equation (1) have distinct characteristics as follows: First, the carry component generated an annualized return of 3.4% with only 0.7% volatility in the entire period, making it the best performer among all the assets in terms of risk-adjusted return, as shown in Table 1. Table 1USD Asset Return-Risk Profile In Different Time Periods Chart 3What Drives The Hedged Return Of EM Local Debt? Second, the hedged return or the EM duration return (i.e. the compensation for a US investor to take on EM interest rate and term premia risks), had a better return/risk profile than US Treasurys in terms of both absolute return and risk-adjusted return, regardless of whether the EM currency index rose or fell against the USD. From January 2003 to January 2021, hedged EM debt returned 4.5% with a volatility of 4.1%, giving a 1.1 return per unit of risk, while US Treasurys returned 3.8% with a volatility of 4.3%, resulting in a 0.9 return per unit of risk. This component is mainly driven by the direction of government bonds in the developed markets as shown in Chart 3. Third, from January 2003 to January 2021, the JPM-implied EM currency had the worst return/risk profile with an annualized loss of 1.7% and annualized volatility of 9.1% (Table 1). However, this component was also the most regime-dependent. Between January 2003 and July 2008 it registered an annualized gain of 7.0% and an annualized volatility of 6.2%, in contrast with the annualized loss of 5.2% and annualized volatility of 9.9% from August 2008 to January 2021. Historically, the EM currency as an aggregate, no matter how the aggregate is calculated, closely correlates to commodities as shown in Chart 4. This is because many EM countries are either commodity producers or have significant trading exposure to China, the dominant player influencing commodity prices as shown in Chart 5. Chart 4EM FX Largely Driven By Commodities Chart 5The Commodities-China Link It is a challenge to build a systematic EM currency model due to the complex nature of EM economies. BCA’s FX Strategy team is working on EM currency models by applying the same approach they used for their DM models. BCA’s EMS Strategy team takes a more discretionary approach to forecasting currencies. Below we will explore two options: one for investors who choose to manage an EM FX hedging program directly and another for investors who cannot manage a direct EM currency hedging program but want to improve their return-risk profile in EM assets. 1.2 Momentum-Based Dynamic Hedging Of EM Currencies Price momentum is a useful tool for dynamic hedging as shown in our previous work on DM currency exposure management. A simple rule of hedging back to the home currency when the 12-month price momentum of a foreign currency turns negative adds value for investors with several DM home currencies. Given that the USD is a strong momentum currency, it makes sense to test if a simple 12-month price momentum rule for the EM FX aggregate vs. USD adds any value. The results are encouraging as shown in Chart 6A and Chart 6B and Chart 7A and Chart 7B. Chart 6AMomentum-Based Dynamic Hedging For EM Bonds Chart 6BMomentum-Based Dynamic Hedging For EM Stocks In the case of EM local debt, dynamic hedging reduced volatility to 8.4% from an unhedged volatility of 11.7%, while only trimming return slightly compared with the unhedged index (Charts 6A, 7A). For EM equities, dynamic hedging cut volatility to 18.6% from the unhedged volatility of 21.1%, while increasing the return by 25 bps, compared to the unhedged index. (Charts 6B, 7B). Chart 7AEM Local Debt Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Chart 7BEM Equities Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** These results are directionally encouraging, but this method still requires hedging all EM currencies. The approach may operationally challenge investors who are not equipped to manage EM currency overlays. Bottom Line: Using only price momentum to hedge EM currency aggregates could improve the return-risk profile of both EM debt and equities, even though the improvements would be limited. This is encouraging for our eventual systematic approach for direct EM currency hedging. 1.3 Correlation Hedge Using DM Currencies EM FX is closely correlated with DM commodity currencies, such as the NOK, CAD, AUD, and NZD. As shown in Charts 8A and 8B, even the euro has an average correlation greater than 60% with EM currency aggregates. Only the JPY has an unstable correlation with the EM currencies of less than 25%, while the GBP also has a relative lower correlation. Chart 8AJPM-Implied EM FX* Correlation** With DM FX Chart 8BMSCI-Implied EM FX* Correlation** With DM FX Therefore, a USD-based investor, instead of hedging out EM currency exposure directly, should be able to eliminate part of EM currency volatility by selling lower-yielding DM currencies. This move would diversify his/her source of funding from USD to other DM currencies with high correlations with EM currencies. To test the effect on the return-risk profile, we use an unfunded overlay of 1-month DM currency forwards and rebalance monthly. To begin, we test a static correlation hedge where each of the eight DM currencies is sold individually. Then we test a dynamic correlation hedge where each one is dynamically sold based on the BCA Forex Strategy Team’s Intermediate-Term Timing Model (ITTM), which uses the same indicators described in our DM currency hedging report. To avoid subjective selection bias among the currencies, we also test an equally- weighted basket of eight currencies (AUD, NZD, JPY, GBP, EUR, CAD, NOK, and SEK) for dynamic hedging and an equally- weighted basket of five currencies (GBP, EUR, CAD, NOK, and SEK) for static hedging. The AUD, NZD, and JPY were excluded in the static hedging basket because in general, AUD and NZD had very high carries and JPY had an unstable correlation with EM currencies. The combined results are shown in Chart 9A and Chart 9B. Additionally, Table 2A and Table 2B list the return-risk profiles together with the fully hedged and unhedged EM indexes for equities and local debt. Chart 9AStatic Correlation Hedge For US Investors Chart 9BDynamic Correlation Hedge For US Investors Table 2AEM Debt Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Table 2BEM Equity Funding Source Diversification For USD-Based Investors (2/2003-1/2021) For US investors investing in EM local currency bonds, the best risk-adjusted return of 1.08 would come from fully hedging all the EM currencies as shown in Table 2A. Fully-hedged EM debt has the lowest volatility (4.12%), but also the lowest return (4.45%). To achieve a comparable return of unhedged EM debt (6.18%) without incurring the same high volatility (11.71%), however, a USD-based investor could either statically sell the five DM currencies or dynamically sell the eight DM currencies. The resulting risk-adjusted return of 0.8 would still be comparable to US Treasurys as shown in Table 1. US investors investing in EM equities may improve their return-risk profile by funding their positions in DM currencies. If the aim is to maximize risk-adjusted returns, then the choice would be to fund the position by selling the basket of equally weighted five DM currencies using currency forwards (i.e. using a static correlation hedge). In this way, they would achieve a comparable volatility (16.25%) as if all the EM currencies were fully hedged to USD (16.29%), while also achieving a higher return (12.29%) than when all the EM currencies were not hedged (11.71%). The return per unit of risk of 0.76 would be the highest among all the cases as shown in Table 2B and be on par with US equities as shown in Table 1. If investors prefer even higher returns without significantly higher volatility, then dynamically selling an equally weighted basket of eight currencies would achieve an annualized return of 13.03% with a higher volatility of 18.71%, resulting in a risk-adjusted return of 0.7. Bottom Line: USD-based asset allocators should use the hedged EM debt index and the unhedged EM equities index as benchmarks to measure the performance of their asset-class managers. The EM currency exposure should be managed in a currency overlay at the total fund level by either statically or dynamically selling DM currencies using a correlation hedge, depending on the return-risk preferences. Part 2: Non-USD-Perspective Six out of the eight non-USD DM currencies have strong positive correlations with EM currencies as shown in Chart 8A and Chart 8B. Therefore, non-USD investors investing in EM assets should naturally experience less spot-currency volatility (Chart 10A and Chart 10B). Consequently, they do not need to hedge EM currency exposure from a volatility perspective. But what about return enhancement? Should they consider an allocation to EM assets in place of domestic assets? If they do, would the correlation-hedge approach used by USD-based investors benefit them too? Chart 10ADM Currency Per Unit Of EM Currency Chart 10BDM Currency Per Unit Of EM Currency To find answers to those questions, we compare the return-risk profiles of domestic assets, unhedged EM assets, and correlation-hedged EM assets in Table 3A and Table 3B. For the correlation-hedged results for non-USD investors, we simply use the results for the US investors converted into the non-USD home currencies at spot exchange rates. This way, the return enhancements from the correlation-hedged EM assets compared to the unhedged EM assets would be similar for all nine currencies. Chart 3AEM-Debt* For Non USD-Based Investors Table 3BEM-Stocks* For Non USD-Based Investors We find that non-USD investors would do better to avoid local-currency EM debt if their objective is to maximize risk-adjusted returns because domestic government bonds had unbeatably low volatility, resulting in the highest risk-adjusted returns, as shown in Table 3A. But domestic government bonds had lower returns than unhedged EM bonds for all but AUD- and NZD-based investors. To further enhance the return-risk profile, non-USD investors could follow their US counterparts by dynamically diversifying their funding sources, then converting their USD returns into their home currency at spot exchange rates (i.e. not hedging the USD exposure). GBP- and JPY-based investors would benefit the most from a dynamic correlation hedge with higher returns and lower volatility compared with the unhedged case. In the case of EM equities, other than SEK- and NZD-based investors, unhedged EM equities have higher returns on an absolute and risk-adjusted basis compared with domestic equities, with GBP-, JPY- and euro-based investors benefiting the most (Table 3B). Even though NOK-based investors increased their returns by only 1% by putting funds into unhedged EM equities, they enjoy lower volatility than in domestic equities. Unlike the case for EM debt where a static correlation hedge did not improve over an unhedged case, both static and dynamic correlation hedges improve the return/risk profiles relative to the unhedged case, and the dynamic hedge outperforms the static hedge in each country. While domestic equities underperform domestic government bonds in terms of risk-adjusted returns, EM equities outperform EM local currency debt when a dynamic correlation hedge is applied. Even in the unhedged case, EM equities are still a much better choice than EM debt (Chart 11). To evaluate how this could impact an asset allocation, we replace home equity with EM equities in a 60/40 home equity/Treasury portfolio. In this extreme exercise, six of the eight non-USD-based portfolios could generate better return/risk profiles, with only the NZD- and SEK-based portfolios worse off (Chart 12). Chart 11Risk-Adjusted Return: Stocks Minus Bonds Chart 12Asset Allocation Implications*     Bottom Line: Non-USD-based investors should avoid EM local debt if their objective is to maximize their risk-adjusted returns. For the purposes of return enhancement, EM equities are a much better choice than EM debt for all investors with the exception of those based in New Zealand and Sweden.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1,2Please see Global Asset Allocation Special Reports, “Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors,” dated September 29, 2017; and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)," dated October 13, 2017. 3 Please see Global Asset Allocation Special Reports, “Why Invest In Foreign Government Bonds?” dated March 12, 2018. 4 Please see "Triennial Central Bank Survey Foreign exchange turnover in April 2019," Bank for International Settlements, dated 16 September 2019.

Special Report

Highlights OPEC 2.0’s production-management strategy and physical supply deficits in base metals will keep growth in demand above that of supply into 2022 (Chart of the Week). Over the next decade, markets will have to reconcile sustaining oil and gas supplies during the low-carbon transition and incentivizing investment in metals used in renewable energy grids. Electric vehicle sales will rise, particularly in China, which has built a commanding position in global EV supply chains. This supports China’s goal of reducing dependence on imported oil, but increases supply-chain concentration risk ex-China. Investors will expect sustainable returns from energy and metals producers and lower CO2 emissions. Otherwise, capital markets will remain parsimonious and investment will be delayed. This will increase price volatility. The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. Differing supply-demand drivers in oil and metals will result in separate, asynchronous bull markets for each, not a global commodity super-cycle. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided the sector can attract funding. Feature Happy families are all alike; every unhappy family is unhappy in its own way. Leo Tolstoy, Anna Karenina   Every commodity market is different in its own way. Over the short term – to the end of 2022 – oil and base metals will appear to be in the early stages of a commodity super-cycle. But, upon closer examination, it is apparent the fundamental drivers for each are, and will remain, different. These markets are entering asynchronous bull markets driven by different fundamentals. The key driver of these cycles is the demand side: Oil demand will rise slightly or remain flat to declining over the next decade, while base metals demand will be rising as a function of actual spending on renewables and EVs. This means the supply side in oil and metals will have entirely different demand expectations to plan for when allocating capex going forward. Chart of the WeekDemand Will Recover Faster Than Supply Chart 2OPEC 2.0 Production Management Keeps Level Of Demand Above Supply Oil markets will be in physical deficits this year and next by design over the next couple of years, with the level of supply maintained below that of demand. This is the result of a deliberate strategy by OPEC 2.0, the producer coalition formed in late 2016 following the disastrous market-share war launched by the old OPEC cartel in 2014 (Chart 2).1 Metals markets – particularly copper and aluminum, which are critical for the transition to renewable generation – likely will be in physical deficits this year and next as well, with the level of demand above that of supply. Copper demand was exceptionally strong in the wake of a construction boom in China last year, which drew inventories from around the world (Chart 3).2 Aluminum demand in China also moved higher last year and likely will continue this year (Chart 4). We expect the global recovery this year ex-China to pick up the slack resulting from a slowdown in China in 2H21, which will keep these markets tight. Chart 3Copper Will Be In Physical Deficit... Chart 4...As Will Aluminum As the decade progresses, oil and base metals fundamentals will continue to diverge, becoming increasingly different it their own ways. Asynchronous Bull Markets: Oil First Oil demand’s rate of growth will slow as the decade progresses, but we believe OPEC 2.0’s production management strategy will continue to keep supply at a level that supports a Brent crude oil price range that accommodates both Saudi and Russian goals. Saudi Arabia’s preferred price range for Brent crude oil is, we believe, in a range of $70-$75/bbl, which allows the Kingdom to fund its diversification away from oil exports as the dominant source of GDP growth. Russia's goal is to keep price incentives for US shale producers at a minimum. Its ideal price range is between $50-$55/bbl. Neither the Kingdom of Saudi Arabia (KSA) nor Russia benefits from launching another internecine price war. Both states have endured repeated policy-induced shocks – e.g., the imposition of sanctions on Iranian crude oil exports in 2018, which was followed by waivers to Iran’s eight largest importers just before this export ban went into effect, then removed the waivers – and the pandemic demand shock this past year. Neither do they benefit from pushing Brent prices too far above $75/bbl over the next couple of years, given the fragile state of the global economy. Besides putting a dent in demand, it also would incentivize US shale production, which can ramp quickly, or encourage EV sales. This could even encourage a push to find alternatives in a market where supply chains for battery materials – chiefly cobalt and graphite – and copper are dominated by China. OPEC 2.0’s preferred range likely will be widened out to $65-$80/bbl for Brent by 2025. Given the trajectory we expect for global demand – global demand returns to pre-COVID-19 levels in 2023 – OPEC 2.0 should be able to continue with its strategy until 2024-25, making use of its spare capacity and low-cost production (Chart 5). Our demand estimates are driven by GDP estimates from the World Bank and the IMF, and we assume, at least until 2025, OPEC 2.0 will maintain its level of supply just below the level required to completely offset demand, to keep inventories from registering another round of unintended growth. This will, per the OPEC 2.0 strategy we believe is in place, keep the forward Brent curve – and by extension the WTI and other benchmark forward curves – in backwardation, which will limit the level at which producers outside the coalition can hedge forward revenues. We do not believe OPEC 2.0 wants to aggressively invest in increasing crude-oil production capacity, given the diversification goals of its core producers – i.e., those states capable of actually maintaining current production levels and increasing them if needs be.3 Chart 5OPEC 2.0 Will Match Production To Consumption Beyond 2025 and out to 2030, the supply side of the oil market becomes more cloudy. We believe core-OPEC 2.0 will be able to source capital without significant constraint, unlike the US shale producers at present. However, core-OPEC 2.0 alone cannot keep the market balanced out of its production alone, nor does it wish to launch 20- to 30-year projects when it becomes more uncertain by the year how much oil and gas is going to be needed by the market once renewables kick into high gear. OPEC 2.0 will need the US shales to increase production, along with Canada, Brazil and the North Sea, once it has exhausted its spare capacity and low-cost production that is readily available. At that point, availability of capital becomes critical, particularly following the capex reductions in the wake of the OPEC market-share war from 2014-16, the Trump waivers, and the short-lived market-share war launched by Russia in March 2020, following the breakdown of OPEC 2.0 negotiations last year to extend production cuts. The International Energy Forum (IEF), a transnational study group headquartered in Riyadh comprised of representatives from energy producer and consumer states, released a report in December showing global oil and gas capex fell 34% y/y in 2020 (Chart 6), and likely will fall another 20% in 2021 to ~ $200 billion (Chart 7). By 2030, the IEF estimates an additional $225 billion will be required in capex -- in addition to its previous estimate of close to $300 billion by then -- “to stave off a crisis.” If capital remains scarce, oil-price volatility will increase as supply growth contracts and prices move higher. At that point, prices will not be moving sharply higher per OPEC 2.0's production-management strategy. Chart 6Oil + Gas Capex Collapses In COVID-19’s Wake Chart 7Global Oil + Gas Capex Will Require A Sharp Boost By 2030 Base Metals’ Decade Spending on renewable energy last year was ~ $700 billion, according to the IEA.4 This could go to $3.4 trillion by 2030, of which $2.7 trillion could be spent on solar and wind power.5 The growth in solar and wind will require sharply higher volumes of tradeable metals important to investors, i.e., aluminum, copper, and nickel (Charts 8 & ​​​​​​9). Chart 8Solar Investment Will Soar… Chart 9…Along With Investment In Wind Energy Aluminum and copper will account for ~ 85% and 11% of solar inputs respectively; iron will account for close to 85% of wind inputs (mostly the towers), with copper making up more than 4%; nickel will account for almost 60% of inputs into new geothermal renewable generation, according to the World Bank.6 The other big slug of base metals demand comes from EVs. A battery-powered EV can contain more than 180 pounds of copper vs up to 50 pounds for conventional autos. By 2030, the demand from EVs alone would amount to close to 4mm tons of copper per year, if demand for these vehicles grows in line with the IEA’s aspirational goals (44mm units/yr). Even if that growth is delayed, this still is a significant share of total demand in a market that consumes ~ 26mm tons/yr. Nickel demand also will surge if EV demand grows in line with IEA projections. By 2040, nickel-intensive battery technology could lift demand by close to 300%, to 2.6mm tons, according to Roskill Information Services. By 2050, nickel demand could increase by as much as 3.7mm tons (Chart 10).7 Chart 10Nickel Demand Could Rise Parabolically Bull Markets, But Not A Super-Cycle … Yet It is true oil and base metals markets are tight, and likely will get tighter over the next couple of years. As the global economy recovers from the COVID-19 pandemic, demand for these commodities will rise, and supply will be constrained. However, it is important to note the supply-side constraints are idiosyncratic – different in their own ways: Oil supply will remain tight as a consequence of OPEC 2.0’s production-management strategy. Base metals – particularly copper and aluminum – will be tight owing to actual supply constraints in the face of strong demand. Over the course of the next decade, we will see asynchronous bull markets for each, not a global commodity super-cycle. Oil will behave like a commodity in its sunset phase, regardless of whether that is true: Firms in the industry are turning toward renewables and away from oil (e.g., Shell and BP). Base metals, because of their criticality to renewables and EVs, will behave like a commodities in their early-growth phase. The evolution of base metals demand as renewables and EV demand increases is difficult to estimate without solid metrics re spending, output goals and timelines. Of course, higher metals output will require higher capex to meet increasing demand for renewable energy and EVs. Just how much output will have to rise is completely unclear: Governments have yet to fully specify their goals or the budgets that will be supporting renewables demand. Whether EV demand meets the IEA’s aspirational goals is anyone’s guess, particularly as the concentration risk in the EV battery supply chain remains acute. The Biden administration appears poised to direct significant investment to reducing US exposure to battery supply chains’ concentration risks – e.g., ~ 80% of EV batteries supply chains are controlled by China – and other exposures.8 Oil output will require higher capex to maintain production to the point where it can meet declining demand. Successful technology work-arounds – e.g., carbon capture, use and storage – would keep oil and gas competitive, provided they attract funding. Bottom Line: The investment required to transition to renewables almost surely will result in higher oil and metals prices. If this transition increases CO2, GHGs and atmospheric particulates, producers will confront more regulation and higher costs. We remain bullish and retain our exposure to oil and base metals. While our recommendations are meant to be strategic, managing these exposures will require tactical agility.     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1    Please see Oil Markets Steady, Despite Weather; Brent Forecast Back At $65/bbl For 2021, published 18 February 2021, for additional discussion of OPEC 2.0’s production-management strategy. It is available at ces.bcaresearch.com. 2    Please see Copper Surge Welcomes Metal Ox Year, which we published 11 February 2021. 3    These core producers, in our estimation, are KSA, Russia, Kazakhstan, Kuwait and the UAE. Others like Nigeria, Iraq and Libya are capable of increasing production, but their output is volatile. The other member states either are managing to a flat or declining profile. 4    Please see World Energy Investment 2020 (p. 8), published by the IEA in 27 May 2020. 5    Please see $3.40 Trillion to be Invested Globally in Renewable Energy by 2030, Finds Frost & Sullivan. 6    Please see our 26 November 2020 report entitled Renewables, China's FYP Underpin Metals Demand for further discussion. 7    Please see Nickel's Decade-Long Rally Is Underway, which we published last week. It is available at ces.bcaresearch.com. 8    Please see Nickel, cobalt price: 10 charts show China’s grip on battery supply chain to last decades published by mining.com 26 February 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Dear Client, In addition to this week’s abbreviated report, we are sending you a Special Report on Bitcoin. I don’t recommend you buy it. Best regards, Peter Berezin Highlights Real government bond yields have increased in recent weeks, which could put further downward pressure on equity prices in the near term. Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. Historically, rising real yields have been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Investors should favor cyclical and value-oriented stocks over defensive and growth-geared plays. Higher Real Yields: A Near-Term Risk For Stocks Chart 1Government Bond Yields Have Increased Since Bottoming Last Year Bond yields have jumped in recent weeks. After bottoming at 0.52% in August, the US 10-year Treasury yield has climbed to 1.54%, up from 0.93% at the beginning of the year. Government bond yields in the other major economies have also risen (Chart 1). While inflation expectations have bounced, the most recent increase in yields has been concentrated in the real component of bond yields (Chart 2). Optimism about a vaccine-led global growth recovery, reinforced by continued fiscal stimulus – especially in the US – has prompted investors to move forward their expectations of how soon and how high policy rates will rise (Chart 3). Chart 2AThe Real Component Has Fueled The Most Recent Rise In Bond Yields (I) Chart 2BThe Real Component Has Fueled The Most Recent Rise In Bond Yields (II) How menacing is the increase in bond yields to stock market investors? Chart 4 shows that there has been a close correlation between real yields and the forward P/E ratio at which the S&P 500 trades. The 5-year/5-year forward real yield, in particular, has moved up sharply, which could put further downward pressure on stocks in the near term. Chart 3Path Of Expected Policy Rates Being Revised Upwards Chart 4Rise In Real Rates Is A Headwind For Equity Valuations Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. As we pointed out two weeks ago, rising real yields have historically been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. In his testimony to Congress this week, Jay Powell downplayed inflation risks, stressing that the US economy was “a long way” from the Fed’s goals. He pledged to tread “carefully and patiently” and give “a lot of advance warning” before beginning the process of normalizing monetary policy. We expect the 10-year Treasury yield to stabilize in the 1.6%-to-1.7% range, still well below the level that would threaten the health of the economy. Favor Cyclical And Value-Oriented Stocks In  A Weaker Dollar Environment The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with US trading partners (Chart 5). Since the Fed is unlikely to tighten monetary policy anytime soon, US short-term real rates could fall further as inflation rises.  Chart 5The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials Chart 6Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar   Cyclical stocks, which are overrepresented outside the US, tend to benefit the most from strengthening global growth and a weakening dollar (Chart 6). Value stocks also generally do well in a weak dollar-strong growth environment (Chart 7). Moreover, bank shares – which are concentrated in value indices – typically outperform when long-term bond yields are rising (Chart 8). Chart 7AA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) Chart 7BA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II)     Chart 8Bank Shares Typically Excel When Long-Term Bond Yields Are Rising In contrast, as relatively long-duration assets, growth stocks often struggle when bond yields go up. The same is true for more speculative plays such as cryptocurrencies. In this week’s Special Report, we discuss the fate of Bitcoin, arguing that investors should resist buying it.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com     Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Special Report

Highlights The price of Bitcoin has surged this year as the digital currency has gained increasing acceptance. Just as was the case with gold, a global financial system built around Bitcoin would be precariously unstable. Bitcoin transactions are expensive to make and slow to execute, making the currency unsuitable as a medium of exchange. Bitcoin miners consume more energy than many countries. ESG funds are likely to shun companies that associate themselves with the currency. Governments, which stand to lose billions of dollars in seigniorage revenue, will put up more obstacles to Bitcoin. As a result, Bitcoin will lose most of its value over time. Bitcoin And Bullion: Back To The Future? Modern banks grew out of the activity of goldsmith guilds during the Middle Ages. Not only did goldsmiths craft beautiful items from precious metals, but because they had to maintain adequate security, they also tended to offer safekeeping services. Chart 1An Inelastic Money Supply Historically Led To More Banking Crises A wealthy merchant who deposited some gold coins with a goldsmith would receive a receipt validating his claim on the coins. Rather than rushing back to the goldsmith to withdraw some coins in order to make a purchase, it became common practice to offer the receipt instead. To facilitate commerce, goldsmiths began to offer receipts for specific values, marking the creation of the first proto-banknotes. On a typical day, only a small fraction of the gold held on deposit would be withdrawn. As long as goldsmiths always had enough gold on hand to meet demand, they could issue notes in excess of the amount of gold that they held in their vaults. Sometimes the goldsmiths would use those additional notes to purchase goods for themselves. Other times, they would lend out the notes, with interest charged to the borrower. The fractional reserve banking system was born. As the fledgling banking system evolved, it became more sophisticated. Nevertheless, it continued to suffer from a fundamental flaw: It was highly vulnerable to self-fulfilling crises. If people began to fear that a bank would run out of gold reserves, they would rush to the bank to be the first to withdraw their funds. Chart 1 shows that bank runs were very common during the 19th century. What Is Bitcoin Good For? Not Much When Bitcoin enthusiasts talk about a world in which global finance is centred on cryptocurrencies, they see the future. Personally, I see the past. John Maynard Keynes famously called the gold standard a barbarous relic. He had a point. A world based on the “Bitcoin standard” would be just as chaotic as the one that was built on the gold standard. Bitcoin’s defenders would argue that the digital currency has advantages that gold, and more importantly, fiat money do not have. But what exactly are those advantages? It certainly is not ease of use. Whereas the Visa network processes nearly 25,000 transactions per second, the Bitcoin mempool, the pool of unconfirmed transactions, has trouble handling five (Chart 2). Bitcoin transactions take 10 minutes to an hour to complete compared to just a few seconds for most debit or credit cards. The average fee for a Bitcoin transaction is around $30 – a number that has been rising over the past year (Chart 3). Chart 2Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 3Bitcoin: The Cost Per Transaction Is Rising Crypto-optimists insist that these impediments will recede over time. However, this is far from certain. Efforts to expedite Bitcoin transactions have run into “fundamental issues.” Markus Brunnermeier and Joseph Abadi have argued that no cryptocurrency can fully satisfy the three desirable properties of decentralization, correctness, and cost-efficiency. Unlike centralized institutions such as banks, blockchain technology works by generating a sort-of consensus among its participants about what constitutes a legitimate transaction. By its nature, the process tends to be very resource-intensive. Bitcoin’s Big Environmental Footprint Chart 4Bitcoin Is Not Your Eco-Currency (I) This raises another problem with Bitcoin: Its environmental impact. A single Bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions (Chart 4). Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 5). The Bitcoin algorithm requires that “miners” solve computationally intensive problems to earn new coins. It should be stressed that the solutions to these problems have no social value. Miners are not solving protein-folding algorithms that are useful for the discovery of new drugs. They are basically wasting CPU cycles by competing with one another to guess extremely large numbers in the hopes of acquiring a shrinking volume of new coins (the total number of Bitcoins that can ever be produced is limited to 21 million). Chart 5Bitcoin Is Not Your Eco-Currency (II) To make matters worse, more than two-thirds of Bitcoin mining takes place in China, where electricity is primarily generated using coal. Companies that claim to be environmentally conscious have no business trafficking in Bitcoin. What Explains The Bitcoin Bubble? Given the seemingly intractable existential problems that Bitcoin faces, why has its price gone through the roof? To some extent, the euphoria over Bitcoin is part of a broader speculative mania that has swept over everything from shares of electric vehicle companies to dubious SPACs and highly shorted “meme stocks.” No commentary about Bitcoin on the internet is complete with an obligatory prediction that it is “going to da moon.” Chart 6Lower Spending And Higher Income Led To Mounting Excess Savings Occasionally funny late-night talk show host John Oliver has joked that Bitcoin is “everything you don’t understand about money combined with everything you don’t understand about computers.” When people don’t have a good basis for determining what something is worth, they can let their imaginations run wild, causing prices to become unhinged from reality. Bitcoin and other cryptocurrencies are especially susceptible to feedback loops because they rely on network effects: The more people that use Bitcoin, the more appealing it is for others to use it. PayPal’s decision to let its customers trade Bitcoin on its platform, as well as Tesla’s announcement that it will accept it as payment, have stoked hopes that the digital currency is about to go mainstream. A surfeit of savings has also helped propel Bitcoin. US households accumulated $1.5 trillion in excess savings in 2020, two-thirds of which came from spending less than they normally would (Chart 6). The counterpart to the savings glut is a dearth of high-yielding assets. Bitcoin does not generate any cash flow, but with real rates still in negative territory, the prospect of capital appreciation has been more than enough to compensate investors for that deficiency. Bitcoin: Risks Tilted To The Downside Of course, if the price of Bitcoin were to start trending lower, speculators could flee the currency en masse. And therein lies the problem: If people decide that Bitcoin is not worth much, then it will not be worth much. Chart 7The Uses Of Gold: A Breakdown One could argue that the same risk plagues gold. There is some truth to this argument, but it should be noted that gold does have alternative uses, most notably jewelry. According to the World Gold Council, jewelry comprised 46% of the above-ground stock of gold at the end of 2020. Private investors held 22% of the gold stock, while central banks held 17% (Chart 7). Bitcoin has absolutely no alternative use to fall back on. Whereas central banks have been willing to hold gold as part of their external reserves, the same courtesy is unlikely to be extended to Bitcoin. The existence of fiat currencies gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin would deprive them of that power. Governments derive significant benefits from the ability of their central banks to create money out of thin air and use it to purchase goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. Bitcoin threatens this stream of revenue. Speaking to The New York Times DealBook conference on Monday, Treasury Secretary Janet Yellen panned Bitcoin: “To the extent it is used I fear it’s often for illicit finance” she said, adding “It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.” Many companies have cozied up to Bitcoin in order to associate themselves with the digital currency’s technological mystique. As ESG funds start to flee Bitcoin, its price will begin a downward spiral. Stay away.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com