Consumer

Highlights Investors have grown enamored with online retailers (AMZN), payment processing companies (V, MA, PYPL, SQ), and social media companies (FB, SNAP). All three sectors are likely to experience headwinds over the next 12 months as life returns to normal following the pandemic. Looking further out, market saturation, increased competition, and heightened regulation all pose risks to these sectors. Internet companies in general, and social media firms in particular, will face increased scrutiny not just for their monopolistic practices, but for the mental harm they are causing young people. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. We think there is a 50/50 chance that governments will start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Global Growth Will Remain Above Trend Investors are worried about growth again. Globally, the number of Covid cases is on the rise due to the proliferation of the Delta variant (Chart 1). The ISM manufacturing index dropped to 59.5 in July, down from a high of 64.7 in March. Both of China’s manufacturing PMIs have fallen, with the new orders component of the Caixin index dipping below the 50 line. The European PMIs have also come off their highs (Chart 2). Chart 1Number Of Covid Cases On The Rise Globally Due To The Delta Variant These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 2Manufacturing PMIs Are Off Their Highs Manufacturing PMIs Are Off Their Highs Manufacturing PMIs Are Off Their Highs     Growth concerns have registered in financial markets (Chart 3). After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.22%. Cyclical equity sectors have underperformed defensives. Growth-sensitive currencies such as the Swedish krona and the Australian dollar have weakened. We are more upbeat about global growth prospects than the consensus. As the experience of the UK demonstrates, there is little will to impose lockdowns in countries with ample access to vaccines. Strict social distancing restrictions remain a fact of life in countries lacking adequate vaccine supplies. However, the situation should improve later this year as vaccine production increases (Chart 4). Chart 3Financial Markets Trim Growth Expectations Financial Markets Trim Growth Expectations Financial Markets Trim Growth Expectations Chart 4Over 10 Billion Vaccine Doses Will Be Produced This Year These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth   Households in developed economies are sitting on US$5 trillion in excess savings, half of which reside in the United States (Chart 5). Inventories are at record low levels, which should support production over the coming quarters (Chart 6). Chart 5Households Flush With Excess Savings Households Flush With Excess Savings Households Flush With Excess Savings Chart 6Record Low Inventories Will Provide A Boost To Production Record Low Inventories Will Provide A Boost To Production Record Low Inventories Will Provide A Boost To Production     Chinese policy should turn more stimulative, as the recent cut to bank reserve requirements foreshadows. With credit growth back down to 2018 lows, policymakers can afford to give the economy some juice. The 6-month credit impulse has already turned up (Chart 7). From Goods To Services While global growth should remain well above trend for the next 12 months, the composition of that growth will shift in ways that could meaningfully affect equities. As Chart 8 illustrates, aggregate US consumption has returned to its pre-pandemic trend. However, spending on goods is 11% above trend while spending on services is still 6% below trend. Chart 7Chinese Policy Is Turning More Stimulative Chinese Policy Is Turning More Stimulative Chinese Policy Is Turning More Stimulative Chart 8The Divergence Between Goods And Services Spending The Divergence Between Goods And Services Spending The Divergence Between Goods And Services Spending   Households typically cut spending on durable goods during recessions, while services serve as the ballast for the economy. The opposite happened during the pandemic. As the global economy recovers, goods spending will slow while services spending will stay robust. This is critical for online retailers such as Amazon, which derive the bulk of their e-commerce revenue from selling goods. Even after its disappointing Q2 earnings report, analysts still expect Amazon to grow e-commerce sales by 17% in 2022 (Chart 9). Such a goal may be difficult to achieve, given that core US retail sales currently stand 13% above their trendline (Chart 10). Chart 9AAnalysts’ Great Expectations May Be Dashed (I) These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 9BAnalysts’ Great Expectations May Be Dashed (II) These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 10AUS Retail Spending Is Well Above Trend (I) US Retail Spending Is Well Above Trend (I) US Retail Spending Is Well Above Trend (I) Chart 10BUS Retail Spending Is Well Above Trend (II) US Retail Spending Is Well Above Trend (II) US Retail Spending Is Well Above Trend (II) Chart 11Screen Time Is Moderating These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth If e-commerce spending slows, shares of payment processing companies could disappoint. Likewise, social media companies could suffer as people start going out more often. After spiking during the height of the pandemic, growth in data usage has returned to normal (Chart 11). Long-Term Risks Looking beyond the post-pandemic recovery, all three equity sectors face structural challenges that are not being fully discounted by investors. The first is market saturation. Close to three-quarters of US households have Amazon Prime accounts. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Competition is another challenge. Companies such as Amazon, Facebook, and Google dominate their respective markets. As they look for further growth, they will invariably invade each other’s turf. The result might benefit consumers, but it is unlikely to help the bottom line if it means more competitive pressures. Moreover, it is not just competition from within the tech industry that may disrupt incumbent firms. Consider payment processors. Like most other central banks, the Fed is planning to launch its own digital currency. Widely available, free-to-use Central Bank Digital Currencies (CBDCs) could thwart the ability of Visa and MasterCard to skim 2%-to-3% off of every transaction. Regulatory Pressures In recent years, tech companies have faced increased scrutiny over their alleged monopolistic practices. In contrast to Chinese tech firms, which have fallen under the thumb of the authorities, US companies have been able to evade harsh measures. Just last month, a US federal court judge dismissed a case filed by more than 40 state attorneys general arguing that Facebook’s acquisitions of Instagram and WhatsApp had harmed competition. In the past, evidence that companies were setting prices well above marginal costs could be used to build a case for anti-trust enforcement. Such cases are more difficult to argue today because so many online services are given away for free. Nevertheless, governments are likely to become more adept in pursuing regulatory actions. Rather than focusing simply on pricing policies, regulators are increasingly looking at the ways big tech companies use vendor data in the case of Amazon and user data in the case of Facebook and Google to maintain market dominance. Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted earlier this year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019. The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 1). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 1American Views On Big Tech These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth A Drug Worse Than Nicotine? Social media companies are among the most loathed within the tech sector. A Pew Research Center study conducted last year revealed that more than six times as many Americans had a negative opinion of social media as a positive one (Chart 12). The public’s disdain for social media is increasingly going beyond traditional concerns over privacy. As psychologists Jonathan Haidt and Jean Twenge recently argued in the New York Times, there is growing evidence that the pervasive use of social media is harming the mental health of the nation’s youth. The share of students reporting high levels of loneliness has more than doubled in both the US and abroad over the past decade (Chart 13). Chart 12Social Media Increasingly Vilified These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 13Alone In The Crowd These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth In 2019, the last year for which comprehensive data is available, nearly a quarter of girls between the ages of 12 and 17 reported experiencing a major depressive episode over the prior year, up from 12% in 2011 (Chart 14). Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. Facebook and most other social media companies already restrict access to those under the age of 13, although enforcement is generally spotty. We assign a 50/50 chance that governments start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Priced For Perfection The seven companies in the three high-flying sectors mentioned in this report trade at 91-times forward earnings compared to the S&P 500’s aggregate multiple of 22. They also trade at an average price-to-sales ratio of 16 compared to 3.2 for the broader market (Chart 15). Chart 14The Rise In Depression Rates Coincided With Increased Social Media Usage These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 15Trading At A High Multiple To Sales These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth   Such valuations can be justified only if these companies grow earnings-per-share by nearly 30% per year over the next five years, as analysts currently expect (Chart 16). However, as noted above, that may be too high a hurdle to clear. Higher bond yields represent another threat to valuations. Growth stocks are much more sensitive to changes in discount rates than value stocks. Chart 17show that tech stocks have generally outperformed the S&P 500 over the past four years whenever bond yields were falling. We expect bond yields to rebound over the coming months, with the 10-year yield rising to 1.8% by early next year. Tech is likely to lag the market in that environment. Chart 16Long-Term Growth Estimates May Be Too Optimistic For These High-Fliers These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Chart 17Higher Bond Yields Could Hurt Tech Stocks Higher Bond Yields Could Hurt Tech Stocks Higher Bond Yields Could Hurt Tech Stocks   Trade Update Our long EM equity trade got stopped out last Tuesday before recouping some of its losses in subsequent days. We continue to expect EM stocks to bounce back later this year. That said, in keeping with this report, we see more upside for “traditional” EM sectors such as banks, industrials, energy, and materials than for EM tech (especially Chinese tech). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth Special Trade Recommendations Image Current MacroQuant Model Scores These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth

Feature June’s economic data and second-quarter GDP indicate that China’s economic recovery may have peaked. Slight improvements in some sectors, including manufacturing investment, exports and consumption, were offset by slowing in China’s old economy, such as infrastructure and real estate. A softening economy will weigh on Chinese corporate profits in 2H21. Inflation in Producer Price Index (PPI) has likely peaked, but it remains far above its historic average. Downstream industries may benefit from low interest rates and slightly less inflationary pressures on input prices, however, their profit growth has rolled over given weakening domestic demand and base effect. Industrial profits will shift downward in 2H21, meanwhile China’s macro policy will probably disappoint investors. Last week’s GDP’s numbers show that small-to-medium enterprises (SMEs) and private-sector businesses bore the brunt of rising global commodity prices and a slow recovery in domestic household consumption and services. The data, coupled with recent policy moves, support our view that China’s leadership is focused on helping vulnerable segments of the economy rather than boosting domestic demand by broadly easing policies (Chart 1). Nonetheless, the authorities may resort to easing policy later in 2021 if export growth weakens significantly in the second half of the year. A series of Reserve Requirement Ratio (RRR) and/or interest rate cuts, increased infrastructure project approvals, and/or looser real estate regulations, will signal that China’s ongoing policy tightening cycle has ended. In recent weeks both Chinese onshore and offshore stocks slipped further in absolute terms and relative to global benchmarks (Chart 2). We continue to recommend that investors remain cautious on Chinese stocks, at least through Q3. Chart 1No Broad Easing Yet No Broad Easing Yet No Broad Easing Yet Chart 2Investors Still Cautious On China's Economy And Policy Investors Still Cautious On China's Economy And Policy Investors Still Cautious On China's Economy And Policy   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Q2 GDP: Recovering At A Slower Pace China’s official GDP growth, on a year-over-year basis, slowed to 7.9% in Q2 from 18.3% in Q1 (Chart 3, top panel). While Q2’s weaker reading reflects the base effect in the data, it was slightly below the market’s expectation of 8.0-8.5%. Moreover, on a sequential basis (quarter-over-quarter), Q2’s seasonally adjusted GDP growth was one of the slowest in the past decade (Chart 3, bottom panel). These figures and the underlying data highlight that China’s economic growth momentum, which historically lags the credit impulse by six to nine months, has peaked (Chart 4). However, in 1H21, China aggregate output still grew by a 5.5% average annual rate during the same period over the past two years, well within Chinese policymakers’ target of above 5% growth needed to maintain a stable economy.  Meanwhile, the bifurcation in China’s economic recovery continues.  While robust external demand for Chinese goods helped to underpin manufacturing output, the sector’s profit growth has lagged upstream industries. Moreover, state-owned enterprises (SOEs) are experiencing soaring profit growth whereas SMEs have struggled with rising global commodity prices and sluggish domestic consumption as discussed below. We expect that the pace in credit growth deceleration will moderate in 2H21 and interest rates will stay at historically low levels. However, the authorities are unlikely to loosen macro policies until more signs of economic weaknesses emerge. Chart 3Q2 GDP: Slowing From An Elevated Level Q2 GDP: Slowing From An Elevated Level Q2 GDP: Slowing From An Elevated Level Chart 4Chinese Economic Growth Should Soften Further In 2H21 Chinese Economic Growth Should Soften Further In 2H21 Chinese Economic Growth Should Soften Further In 2H21   Robust Exports, Sluggish Manufacturing Investment Chart 5Subdued Manufacturing Investment Recovery Despite Robust Exports Subdued Manufacturing Investment Recovery Despite Robust Exports Subdued Manufacturing Investment Recovery Despite Robust Exports China’s export growth in June beat market expectations, despite shipping disruptions at major ports in Guangdong province due to a resurgence in COVID-19 cases. However, the recovery in manufacturing investment was muted through most of 1H21 even though export growth was resilient (Chart 5). There are several reasons for the sluggish recovery: the RMB’s rapid appreciation in the first five months of 2021, rising inflation and the limited pricing power that Chinese exporters gained in the first half of the year likely impeded their profits and curbed their propensity to invest (Chart 6). Total export values in USD significantly outpaced those in RMB terms, suggesting that the profit gains by Chinese exporters were offset by the strengthening local currency (Chart 7). Chart 6Rapid RMB Appreciation Will Weigh On Industrial Profits Rapid RMB Appreciation Will Weigh On Industrial Profits Rapid RMB Appreciation Will Weigh On Industrial Profits Chart 7Divergence Between Exports In USD versus RMB Divergence Between Exports In USD versus RMB Divergence Between Exports In USD versus RMB Furthermore, manufacturers in mid-to-downstream industries have been unable to fully pass on rising input costs to domestic consumers, which is evidenced in the faster growth of manufacturing output volume compared with price increases. It contrasts with the previous inflationary cycles, where surging prices for manufactured goods surpassed output volume (Chart 8A & 8B). Chart 8AChina's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices China's Manufacturing Recovery: Stronger Volume Than Prices Chart 8BMuted Profit Margin Recovery In Manufacturing Compared With Mining Muted Profit Margin Recovery In Manufacturing Compared With Mining Muted Profit Margin Recovery In Manufacturing Compared With Mining June’s improvement in manufacturing investment may not advance into 2H21 without added policy support. The nearly 2% depreciation in the RMB against the dollar in recent weeks will alleviate some pressure on exporters’ profit margins. However, export prices in USD also started to weaken (Chart 9). In addition, June’s manufacturing PMI and a Chinese business school survey,1 reported a deterioration in business conditions among smaller businesses. The weaker sentiment will depress manufacturing investments since China’s manufacturing sector is dominated by private and smaller businesses (Chart 10). Chart 9Chinese Export Prices In USD Are Rolling Over Chinese Export Prices In USD Are Rolling Over Chinese Export Prices In USD Are Rolling Over Chart 10Deteriorating Business Sentiment Will Depress Manufacturing Investments Deteriorating Business Sentiment Will Depress Manufacturing Investments Deteriorating Business Sentiment Will Depress Manufacturing Investments Recent policy measures to keep a low interest-rate environment will help the export and manufacturing sectors by reducing operating costs. The measures are also in keeping with China’s shift from boosting its service sector to maintaining a steady share of manufacturing output in its domestic economy (Chart 11). Chart 11Maintaining A Steady Share Of Manufacturing Output In China's Economy Maintaining A Steady Share Of Manufacturing Output In China's Economy Maintaining A Steady Share Of Manufacturing Output In China's Economy   Policy Tightening In The Old Economy Continues Chart 12Investments In Real Estate Have Lost Steam Investments In Real Estate Have Lost Steam Investments In Real Estate Have Lost Steam Infrastructure investment growth slowed further in June. Investments in real estate, which drove China’s economic recovery in the second half of 2020, are also losing momentum (Chart 12). The slowdown, engineered by policymakers, will likely endure for the rest of the year. Bank loans to real estate developers tumbled to a cyclical low (Chart 13). In addition, deposit and advance payments, the main source of funds for real estate projects, nose-dived along with home sales (Chart 14).  Chart 13No Signs Of Looser Financing Regulations In Property Sector No Signs Of Looser Financing Regulations In Property Sector No Signs Of Looser Financing Regulations In Property Sector Chart 14Falling Home Sales Will Further Depress Real Estate Investments Falling Home Sales Will Further Depress Real Estate Investments Falling Home Sales Will Further Depress Real Estate Investments Chart 15Sharp Pullback In New Infrastructure Project Approvals This Year Sharp Pullback In New Infrastructure Project Approvals This Year Sharp Pullback In New Infrastructure Project Approvals This Year Infrastructure project approvals by the Ministry of Finance remain on a downward trend (Chart 15). Last week, China’s Banking and Insurance Regulatory Commission (CBIRC) announced a new rule to stop financial institutions from lending to local government financing vehicles (LGFV) that hold off-balance sheet government debt. LGFVs are largely used by provincial governments to borrow from banks to help fund infrastructure projects. Regulations targeting the real estate sector will further dampen real estate investments in the second half of this year. Land purchases and housing starts, both leading indicators for real estate investment, have declined since February. Excavator sales and investment in construction equipment also deteriorated sharply (Chart 16). Given that housing prices remain elevated, we do not expect real estate regulations to shift to an easier tone.  The deceleration in China’s old economy is reflected in imports. While the value of imports remains strong, the volume has slowed, which suggests that the surge was due to soaring commodity prices (Chart 17, top panel). In particular, the growth in China’s imports of copper and steel, on a year-over-year basis and in volume terms, contracted in June (Chart 17, bottom panel). Chart 16Construction Activities Set To Slow Further Construction Activities Set To Slow Further Construction Activities Set To Slow Further Chart 17Falling Import Volume Falling Import Volume Falling Import Volume   The Key To A Consumption Recovery Retail sales picked up slightly in June following two consecutive months of decline.  However, retail sales remain below their pre-pandemic level (Chart 18). Labor market dynamics and household income growth, which stayed sluggish through 1H21, hold the key to the speed and magnitude of a recovery in consumption this year (Chart 19). Chart 18Sluggish Recovery In Household Consumption Sluggish Recovery In Household Consumption Sluggish Recovery In Household Consumption Chart 19A Lackluster Consumption Recovery Due To Slow Recovery in Household Income A Lackluster Consumption Recovery Due To Slow Recovery in Household Income A Lackluster Consumption Recovery Due To Slow Recovery in Household Income Household precautionary savings, which remain elevated compared with their historical norms, have depressed the propensity to spend (Chart 20). While the overall unemployment rate in China’s urban centers has steadily declined this year, the rate of jobless young graduates (ages 16-24) picked up and is nearly three percentage points higher than its historical mean (Chart 21). However, the high unemployment among graduates will not encourage policymakers to stimulate the economy. The number of new graduates in both 2020 and 2021 is larger than the historical average, while the growth in new job creation has nearly recovered to that of the pre-pandemic years (Chart 22). Chart 20Households' Propensity For Precautionary Savings Remains Elevated Households' Propensity For Precautionary Savings Remains Elevated Households' Propensity For Precautionary Savings Remains Elevated Chart 21Rising Unemployment Rate Among Younger Workers Rising Unemployment Rate Among Younger Workers Rising Unemployment Rate Among Younger Workers Moreover, labor market slack among young graduates seems to be concentrated in the services sector, and this sector’s improvement is dependent on China’s domestic pandemic situation and inoculation rates rather than on stimulus (Chart 23). Chart 22Urban Job Creation Growth Still On The Mend Urban Job Creation Growth Still On The Mend Urban Job Creation Growth Still On The Mend Chart 23Interruptions In Service Sector Recovery Due To Lingering COVID Cases Interruptions In Service Sector Recovery Due To Lingering COVID Cases Interruptions In Service Sector Recovery Due To Lingering COVID Cases   Elevated Inflation, Downshifting Industrial Profits Chart 24China's PPI May Have Reached A Cyclical Peak... China's PPI May Have Reached A Cyclical Peak... China's PPI May Have Reached A Cyclical Peak... China’s domestic inflationary pressures eased slightly in June with a small decline in both consumer and producer prices. The input price component of the manufacturing PMI, which normally leads the PPI by about three months, dropped sharply last month, which indicates that the PPI may have reached its cyclical peak (Chart 24). However, producer price inflation will likely remain elevated in the second half of the year. Although global industrial metal prices have rolled over since May, they remain at their highest level since 2011 (Chart 25). A rapid deceleration in Chinese credit growth and weakening demand in 2H21 will remove some pressure in the sizzling hot commodity market, but global supply-side constraints will limit the downside in raw material prices, at least through the next six months. Therefore, diminishing inflationary pressures on the PPI will only slightly reduce input costs for China’s mid-to- downstream manufacturers, which have been unable to pass on rising commodity prices to domestic consumers (Chart 26). As discussed earlier, Chinese export prices in both USD and RMB terms have also rolled over. Chart 25...But Global Commodity Prices Are Still Elevated ...But Global Commodity Prices Are Still Elevated ...But Global Commodity Prices Are Still Elevated Chart 26Absence Of Inflation Pass-Through Absence Of Inflation Pass-Through Absence Of Inflation Pass-Through Given that price changes are more important to corporate profits than volume changes, Chinese mid-to-downstream industries will continue to face downward pressure on their profit margins. Profit growth in mid-to-downstream industries consistently lagged their upstream counterparts in the past 12 months (Chart 27). Moreover, state-holding enterprises, which dominate upstream industries, have seen a 150% jump in profit growth from a year ago, while the rate of profit gains among privately owned industrial companies tumbled this year (Chart 28). Chart 27A Faster Mean Reversal In Profit Growth Among Private Companies Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Chart 28A Faster Mean Reversal In Profit Growth Among Private Companies A Faster Mean Reversal In Profit Growth Among Private Companies A Faster Mean Reversal In Profit Growth Among Private Companies Chinese policymakers will probably focus on addressing imbalances in China’s industrial sector and economy by supporting SMEs and the private sector. Meanwhile, industrial profit growth will decline in 2H21 from its V-shaped recovery last year, given weakening domestic demand and the waning base effect. Table 1China Macro Data Summary Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Table 2China Financial Market Performance Summary Taking The Pulse Of China’s Slowing Economy Taking The Pulse Of China’s Slowing Economy Footnotes 1The CKGSB (Cheung Kong Graduate School Of Business) Business Conditions Index (BCI) comprises four sub-indices: corporate sales, corporate profits, corporate financing environment and inventory levels. Equity Sector Recommendations Cyclical Investment Stance

Highlights From a credit perspective, the five largest banks have turned the page on the pandemic: The big banks have returned to their pre-COVID lending standards and, ex-Wells Fargo, have released 70% of the loan-loss reserves they built up in the first half of 2020. Households have a ton of dry powder to support consumption and they’re deploying it with gusto: Consumers have begun to give their plastic a workout, with first half 2021 debit and credit card spending surging well beyond first half 2019 levels. Unfortunately for bank earnings, however, consumers are paying off their balances every month and businesses are still awash in liquidity: Expectations about a second-half lending pickup are mixed. Households and businesses have plenty of cash on hand and it is unclear when they will again need to borrow. Credit performance is stellar: Banks are disappointed that the appetite for new loans is so weak, but ample cash and soaring collateral values have shrunk delinquencies and charge-offs to extremely low levels. What The Banks See Chart 1New Delinquency Lows In All Categories The Big Bank Beige Book, July 2021 The Big Bank Beige Book, July 2021 Another quarterly earnings season began last week with the systemically important banks (BAC, C, JPM and WFC) and USB leading the way. We review their results and their calls for insight into the broad macro backdrop as revealed by the actions and intentions of their household and business customers, borrower performance, lender willingness and the overall state of the financial system. The banks differed on whether business and consumer lending demand will revive before the year is out, but they were unanimous in the view that fiscal transfers have stunted consumer borrowing and that businesses won’t need to borrow until they work through their own excess cash holdings. The flood of cash in the system is supporting outstanding credit performance (Chart 1) and every bank released loan loss reserves and foresees releasing more if the expansion continues to follow its current course. We took the banks’ observations as confirmation of our view that the economy is in very good shape and is poised to grow far above trend well into 2022. Household spending has come roaring back, reviving the prospects for industries that languished throughout the pandemic, like dining, travel, lodging and entertainment. Businesses have raised plenty of cash from lenders and investors, but they’ve also been generating it via more efficient operations. They will help keep the momentum going as they hire, invest, and restock depleted inventories to meet surging demand. The outlook for the banks’ own stocks is not as clear. Outsized income from lumpy streams like trading and debt and equity underwriting will slow, despite full investment banking pipelines, and most of the benefit from unwinding last year’s buildup of bad debt reserves, except at Wells Fargo, has already been realized (Table 1). The banks cannot unleash their full earnings potential until loan demand recovers and interest rates rise, and their net interest income prospects were top of mind for the analyst community. We do expect the banks will get some relief as longer duration Treasury yields back up to reflect inflation’s stirrings and the economy’s strength, but we are not counting on a major inflection in lending demand. Absent a backup in yields, we do not yet see a catalyst for the five biggest banks to outperform the S&P 500 over the rest of the year. Table 1Not Many More Reserves Left To Release The Big Bank Beige Book, July 2021 The Big Bank Beige Book, July 2021 Households Are Spending (Chart 2), … Chart 2Consumption Is Back In A Big Way ... Consumption Is Back In A Big Way ... Consumption Is Back In A Big Way ... [C]onsumer spending from our own customers … is not only much higher than … in 2020, which you would expect, but is notably 22% higher … compared to 2019. (Moynihan, BAC CEO) [C]ombined debit and credit [card] spend was up 45% year-on-year, and more importantly up 22% versus the more normal pre-COVID second quarter of 2019. (Barnum, JPM CFO) [T]he pump is primed. … The pandemic is kind of in [consumers’] rearview mirror … and they’re raring to go. (Dimon, JPM CEO) In Branded Cards, total purchase sales were up 40% versus last year and, importantly, up 11% versus the second quarter of 2019. And in Retail Services, purchase sales also grew versus … second quarter 2019[.] So, the good news is that we’re continuing to see the recovery in spend. (Mason, C CFO) Weekly debit card spend was up every week compared to 2019 during the second quarter and areas hardest hit by the pandemic have recovered, including travel, up 11%; entertainment, up 38%; and restaurant spending, up 28% during the week ending June 25th, compared with 2019. Consumer credit card spending activity continued to increase, up 13% in the second quarter, compared to 2019. As of the week ended June 25th, travel … was the only category that has not fully rebounded to [2Q19] levels. (Scharf, WFC CEO) Sales volume trends … are encouraging. As of the end of June, total sales volumes across each of the three payments businesses exceeded comparable 2019 levels. Certain pandemic-impacted spend categories continue to lag, in particular corporate travel and entertainment. However, consumer travel and hospitality spend volumes are rebounding faster than we expected, and the pace of improvement in recent weeks has accelerated a bit. (Dolan, USB CFO) … They’re Just Not Borrowing (Yet) (Chart 3) Chart 3... While Credit Card Debt Has Been Left Behind ... While Credit Card Debt Has Been Left Behind ... While Credit Card Debt Has Been Left Behind [Mortgage balances] are only modestly down this quarter as our origination volumes are finally overcoming the payoffs. We are pleased with the trajectory through the period and that feeds into the second half of the year, … [when it will be] good to start with a trend that has reversed the past quarters’ declines. (Moynihan, BAC) [People’s behavior hasn’t changed;] [t]hey just have more cash, and so they paid off their credit cards, which is a completely responsible thing for them to do. And when they can get out and spend more money, which is starting to happen, I think you’ll see them use these lines[.] … So we’ll see where it goes, but the good news is it’s going in a different direction. (Moynihan, BAC) [W]e … believe that the … acceleration and pickup in spend is going to translate to … loan growth in [credit] card[s], but we think that pay rates are going to remain quite elevated at a minimum through the end of this year [because of households’ cash buffers (Chart 4)]. So as a result, we don’t really see revolving … balances increasing meaningfully this year[.] (Barnum, JPM) Chart 4A Mountain Of Excess Savings A Mountain Of Excess Savings A Mountain Of Excess Savings Looking ahead, we expect the growth in purchase sales to translate into loan growth by the end of the year as stimulus moderates and consumers return to more normal payment patterns. (Mason, C) [W]hile it’s hard to predict exactly what will happen during the second half, … we are seeing signs of green shoots with modest growth … compared to the first quarter in auto, other consumer [and] credit card. (Santomassimo, WFC CFO) You’re seeing a little bit of growth in card [balances]; although [spending] has really picked up, it hasn’t quite translated into bigger volumes given the payment rates … are still really high. I think they’ll come down and normalize eventually, but they’re still pretty high. (Santomassimo, WFC) We do expect consumer lending to get a little bit stronger, because of [consumer spending]. … [W]e saw some nice growth in the credit card space right at the end of June. And while [payment rates] continue to be elevated, I think the fact that they’re not increasing … will help credit card balances as well. And … also when we think about loan growth, auto lending continues to be very strong. (Dolan, USB) Businesses Are In Limbo [E]xcluding the PPP loan forgiveness, middle-market lending and our business banking team [serving companies with annual revenues of $5 million to $50 million] finally had a month of growth in June, the first since March 2020. (Moynihan, BAC) [O]n the commercial side, it’s really [credit] line usage. Honestly, it can’t go any lower – maybe it can, but theoretically it can’t because it’s been stuck here for a good four or five quarters. (Moynihan, BAC) [O]ur commercial committed exposures … grew quarter-over-quarter [and are] above [their] pre-pandemic level, so [businesses] are getting ready to borrow more. [R]evolver utilization is still at historic lows, but we would expect that to move up as the economy improves … [and] inventories are built across various industries. … Some of the inventory building has been hampered by trucking and ocean liner [bottlenecks, but] you could start to see it [once] some of those kinks are worked out. (Donofrio, BAC CFO) I’ve learned a lot more about ports from our customers than I ever thought I would, [and] it’s going to take a while [to iron out supply chain kinks]. … [E]verybody talks about the chip [shortage], … but it really comes down to the efficient operations of ports … and having people to work and unload the ships (Chart 5). [I]t’s still constraining, but it’s getting incrementally better, [and most of our contacts] are saying it’ll all be [resolved by] the end of the year. And we’ll see it [in lending]. (Moynihan, BAC) Chart 5US Ports Are Still Trying To Clear Backlogs US Ports Are Still Trying To Clear Backlogs US Ports Are Still Trying To Clear Backlogs C&I loans were down 1% quarter-on-quarter with lower [credit line] utilization partially offset by new middle market loan activity. (Barnum, JPM) [T]he second the economy starts to grow, … you’re going to see [middle market] loans go up because inventory, receivables and capital expenditures [will need to be financed]. (Dimon, JPM) The general view from our [business] clients is optimistic in terms of the go-forward environment. (Mason, C) [O]ne never wants to jinx these things, but we really have a fabulous pipeline heading into the second half of the year around the world and it gives you a good sense of confidence and continued momentum. (Fraser, C CEO) [T]he [investment banking] pipeline remains very strong. We expect M&A activity and the IPO markets to remain active and investment banking fees … to be up year-on-year. (Barnum, JPM) We saw investment banking close this quarter with record pipelines. (Moynihan, BAC) In the commercial bank, loans are still down and utilization rates are pretty low on a historic basis [for] lots of reasons – high liquidity, supply chain issues, demand for product in certain industries … and we haven’t really seen [loan demand] inflect yet, … [but there are] lots of good conversations. So I think people are really thinking about investments and building inventory levels over the coming quarters, but [it] will take some time before it starts to translate into loan growth. (Santomassimo, WFC) [I]t’s going to take a little bit of time for C&I [lending] to develop simply because of the amount of liquidity that customers have and are continuing to generate. (Dolan, USB) [A]cross our markets, … middle market customers are certainly much more optimistic today than they were even a quarter or two quarters ago. That usually translates into making longer-term … investments. … I do think that the supply chain is impacting it to some extent, but I think that’s more transitory. (Dolan, USB) Banks Are Ready, Willing (Chart 6) And Able (Chart 7) Chart 6Open For Business Open For Business Open For Business [Our] deposits are $1.9 trillion and [our] loans are $900 billion and change, and that difference has got to be put to work. And the reality is we generated $80 billion [of] deposit growth, and we got to put it to work. And that’s what we do. (Moynihan, BAC) [W]e’re going to get deposits. [They’re] going to fund loan growth. Whatever is left over will probably go in securities, but then we still have a bunch of excess liquidity, so that can be deployed as well, either in the near term or long term, depending on how we balance liquidity against capital and earnings. (Donofrio, BAC) One of the significant things that’s going on is we’ve really finished unwinding all of our credit pullbacks from the [global financial] crisis. So we’re fully back in the [home mortgage] correspondent channel. (Barnum, JPM) Chart 7Finally Putting In A Bottom? Finally Putting In A Bottom? Finally Putting In A Bottom? Chart 8Chrome Is The Most Precious Metal Chrome Is The Most Precious Metal Chrome Is The Most Precious Metal We started to tighten our credit policies in March 2020 in response to the pandemic and we have now essentially returned back to pre-COVID levels or policies, however, we continue to be thoughtful of the much higher asset prices in areas like residential real estate and auto (Chart 8). (Santomassimo, WFC) I think we mentioned this last quarter but we’re now back to fundamentally the credit box that we had on a pre-pandemic level really across all the product categories. (Dolan, USB) Investment Implications We remain bullish on the economy and risk assets as we look out six to twelve months. As the banks highlighted, consumer spending is roaring, businesses cannot go much longer without ramping up spending and hiring to meet burgeoning demand and credit performance is spectacular as borrowers and lenders are flush with cash. The S&P 500 is expensive at between 21 and 22 times forward four-quarter earnings, but the analyst consensus is projecting a highly unusual drop in earnings from the prior quarter’s annualized run rate and we expect the second quarter will produce another sizable beat along the lines of the last four quarters. Prospective returns on “safe” investment alternatives are unappealing and we continue to recommend that investors with one-year timeframes overweight equities. Chart 9Losing Ground Losing Ground Losing Ground As for the SIFI banks themselves, we think their significant outperformance versus the overall market has come to an end (Chart 9, top panel). They were ridiculously inexpensive when we were bulled up on them last spring and summer (Table 2) amidst wildly exaggerated potential credit losses but there’s no re-rating or credit performance catalyst on the horizon now. We disagree with our Counterpoint colleagues’ contention that banks are in the midst of a secular earnings decline but we do expect they will find themselves hemmed in over the rest of the year by the overabundance of capital in the financial system. As we noted last quarter, traditional intermediation isn’t very rewarding when every creditworthy borrower has more money than he or she needs. We are comfortable staying on the neutral sidelines with our US Equity Strategy team.1   Table 2Big Bank Valuations Have Mostly Normalized The Big Bank Beige Book, July 2021 The Big Bank Beige Book, July 2021 Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Our Global Investment Strategy team is calling for banks to outperform the overall market, as reiterated in its latest publication.

Highlights Home prices have risen at a rapid rate over the last year, stirring some fears that a new bust could be in store: The housing market is strong, but price appreciation has not been that significant relative to history and popular concerns appear to be misplaced. Banks and households are on much sounder financial footing than they were before the housing bust: Banks’ exposure to residential mortgages has shrunk and stiffer regulatory requirements have made them more resilient to shocks. Households have been de-levering since the crisis and have accumulated massive excess savings since the pandemic began. The housing market is not oversupplied in the aggregate and does not appear as if it will become oversupplied soon: High prices are a reliable cure for high prices, but the housing supply response has been muted and looks as if it will remain so for the immediate future. The Global Financial Crisis had its roots in debauched underwriting standards that bear no resemblance to today’s mortgage lending environment: Before it spread around the world, the GFC was known as the subprime crisis, but subprime borrowers are almost entirely shut out of today’s residential mortgage market. Feature The state of the housing market was a central concern for investors in the wake of the global financial crisis. That incident was initially known as the subprime crisis, as a new class of loans – subprime mortgages – set a self-reinforcing debt-deflation dynamic into motion. When the music stopped, dedicated mortgage originators and securitizers were out of business, a sizable share of borrowers faced foreclosure and a lot of homes, from freshly built subdivisions to tattered urban blocks, stood empty. Many of the people who were a part of the pipeline – making loans, appraising properties, wholesaling loans, packaging loans into securities, trading securities, and building and selling houses – were thrown out of work. As if the consequences in the real economy weren’t bad enough, the convulsions in the financial markets imperiled the banking system. Record mortgage default rates and plunging collateral values left commercial banks gasping, and highly leveraged investment banks holding unsold securities, as-yet-unpackaged whole loans or other property investments found their capital levels whittled nearly to zero. A high-profile insurer was undone by guaranteeing against the securities’ defaults, but several life insurers were squeezed by the losses they sustained on highly rated securities that turned out to harbor a lot of poorly underwritten loans. The net result of the financial distress was a paucity of investment capital to help the real economy get back on its feet. Elected officials, central bankers, regulators and investors are all understandably wary of a repeat of the crisis and its wide-ranging effects. In his press conference after the FOMC’s April meeting, Chair Powell acknowledged the risks before going on to say that they don’t appear particularly strong right now. “So many of the financial crack-ups … that have happened in the last 30 years have been around housing. We … really don’t see that [financial stability concerns] here. We don’t see bad loans and unsustainable prices and that kind of thing.” This Special Report examines why we concur with the Fed’s view. Investors May Be Jittery, But The Banks Are Steady Chart 1Once Bitten, Twice Shy Once Bitten, Twice Shy Once Bitten, Twice Shy This evening in the States we will get on the phone with an Asia-Pacific client who wants to discuss the following topic: “One of the issues that we are currently exploring is the US housing market. It is exceptionally strong and may create an important medium-term risk for the US and global markets.” Internet users closer to home have also taken note of the housing market’s strength and have their own concerns about it. Google searches for “housing crash” by US users are making new highs, dwarfing the interest the phrase drew ahead of the GFC (Chart 1). While potential homebuyers are understandably wary of getting in at the top, and households who already have mortgages are averse to price declines that would erode the value of their equity, it is the overall financial system’s exposure to US home prices that draws global investors’ attention. Such an overwhelming majority of households borrow to buy their home that single-family homes have traditionally comprised the largest component of banking system collateral (Chart 2). Although US banks have less exposure to residential mortgages than their peers in other major developed economies (Table 1), the housing market poses an outsize risk to financial stability by virtue of the amount of debt financing it. Chart 2Moving Beyond Mortgages Moving Beyond Mortgages Moving Beyond Mortgages Table 1Don't Look At Us The US Housing Market: Déjà Vu All Over Again? The US Housing Market: Déjà Vu All Over Again? Since the GFC, however, the largest banks have sharply reduced their exposure to lending (Chart 3, top panel). They have a disproportionate influence on the state of the overall banking system and their offloading of qualifying loans to Fannie Mae and Freddie Mac have helped the system pare residential real estate loans’ share of total assets to 10%, or half of their pre-GFC weight (Chart 3, bottom panel). The wave of post-GFC regulation has forced systemically important banks to hold more capital against their assets, making them more resilient to shocks and the ordinary vagaries of asset markets and the business cycle. Loans account for less than half of all bank assets, with nearly all the rest going to Treasury and agency securities, cash, property and goodwill and fully collateralized short-term loans (Chart 4). Chart 3Big Banks Have Become Much More Judicious Lenders Big Banks Have Become Much More Judicious Lenders Big Banks Have Become Much More Judicious Lenders Chart 4Risk Off Risk Off Risk Off Bottom Line: The banking system is better capitalized than it was in 2007 and has considerably less exposure to residential real estate loans. The financial system is much less vulnerable to a rupture in the housing market than it was 15 years ago. Better Borrowers, Better Loans Household balance sheets are not a source of vulnerability, either, as they are in far better shape than they were before the GFC. Employment gains, increased savings, lender write-offs and lower debt-service costs helped shore up household finances after the crisis, and the pandemic yielded explosive wealth gains via whopping fiscal transfers, reduced spending options and surging stock and home prices. No previous four-quarter stretch has been better for household net worth gains, nominal (Chart 5, top panel) or real (Chart 5, bottom panel), than the one ended March 31st, and even the five-quarter stretch including last year’s disastrous first quarter was quite strong relative to history, especially in real terms. Households have paid down their outstanding credit card balances, and with interest rates at rock-bottom levels, servicing the debt they have has never been easier (Chart 6). Chart 5The Pandemic Has Been Great For Household Net Worth The Pandemic Has Been Great For Household Net Worth The Pandemic Has Been Great For Household Net Worth Chart 6A Light Yoke A Light Yoke A Light Yoke Chart 7Only Qualified Borrowers Need Apply The US Housing Market: Déjà Vu All Over Again? The US Housing Market: Déjà Vu All Over Again? The improvement in aggregate household financial positions would be of little import if lenders repeated their pre-GFC practices of lending to the weakest candidates in the pool of potential borrowers. Fortunately for financial stability and the health of the housing market, the highest-quality borrowers have been capturing an increasing share of new mortgage loans. In a reversal of the underwriting follies of a decade-and-a-half ago, lenders are shunning subprime and near-prime borrowers in favor of the best credits (Chart 7). The current housing boom has been built on a solid credit foundation. Supplies Are Tight As measured by the Case-Shiller 20-City Index, home prices are appreciating at a double-digit clip on a year-over-year basis. The rapid appreciation has helped fuel fears of a housing bubble, but it pales beside the 46-month stretch of double-digit percentage gains from August 2002 through May 2006 (Chart 8). Our Bank Credit Analyst and Global Fixed Income Strategy colleagues have made the case that the current burst of home price appreciation across the developed world has largely derived from generous fiscal transfers and extremely accommodative monetary policy.1 That implies that home prices will not be able to maintain their current pace once the policy support fades, but it does not necessarily foreshadow a looming crash. In our view, policy has contributed to a sugar rush that has briefly quickened price gains, a much less destabilizing condition than the multi-year course of steroid injections provided by the willful abandonment of prudent lending standards that triggered the GFC. Chart 8Nothing Like The Last Boom Yet Nothing Like The Last Boom Yet Nothing Like The Last Boom Yet Despite the run-up in prices, homes remain much more affordable today than they were at the peak of the pre-GFC boom (Chart 9, top panel), thanks to mortgage rates that are about half their 2004-7 level (Chart 9, middle panel). Homebuilders have maintained their discipline this time around, holding new home construction at or below the rate of household formation (Chart 10, top panel) and there is none of the overtrading associated with bubbles, like the flipping at the top of the last cycle. As a share of the total housing stock, inventories of new and existing homes for sale are more than two standard deviations below their four-decade mean (Chart 10, middle panel) and the share of vacant homes, at 0.9%, is sitting at its 65-year series low (Chart 10, bottom panel). Unusually high prices will eventually inspire new sources of supply and push price gains down to levels consistent with their long-run mean; in the meantime, low mortgage rates will likely summon enough demand to prevent the disruption that Google searchers and cranky Austrians fear. Chart 9Affordability Is Still Quite High ... Affordability Is Still Quite High ... Affordability Is Still Quite High ... Chart 10... Even Though Supply Is Tight ... Even Though Supply Is Tight ... Even Though Supply Is Tight Haven’t We Left Something Out? Now wait a minute; you’re trying to have it both ways. You’ve been citing rising wealth for a while, suggesting that it will help foster a virtuous growth cycle that will last through next year, six or seven quarters after the final stimulus checks were cut. Home prices have been a part of that wealth surge but you’re ignoring what will happen once they stop defying gravity. We have been tracking aggregate household income, spending and savings for over a year and the growing pile of savings has been a key pillar of our argument that the economy will grow way above trend. Our running estimate of excess pandemic savings is now up to $2.4 trillion through May. That’s quite a lot even in a $21 trillion economy, and if it were all spent over a two-year period, GDP would grow by 10% more than it otherwise would. There is no close precedent for the income windfall that up to three-fourths of households have received since the pandemic began, so we cannot turn to regression models for an estimate of the savings’ near-term impact. However, it's important to recognize the money was directed at households below the top rungs of the income scale with a higher marginal propensity to consume, especially the federal unemployment insurance benefit supplements, which wound up going largely to the lowest-paid workers who bore the brunt of pandemic layoffs. Our working assumption is that around half of the savings will be spent across 2021 and 2022, which would push output over the period higher by more than 5%. We don’t care about GDP growth per se, but it does impact the outlook for corporate earnings, household income and credit performance. We have viewed the savings developments as making an important contribution to the positive macro backdrop for investments in equities and credit and expect they will continue to do so well into next year. Although we expect the returns on risk assets to slow, we anticipate that they will continue to exceed returns from Treasuries and cash and therefore maintain our overweight recommendations on equities and spread product. The household net worth gains from financial asset and home price appreciation haven’t factored much into our view. Though their advances have far outpaced the increase in savings, mainstream economic models consider their effects on consumption to be modest. Most of the gains are captured by wealthier households, who are more apt to save wealth increases than spend them, and our rule of thumb is that five cents and three cents of every dollar of stock and home price gains are spent, respectively. By that measure, the $7.4 and $3.2 trillion advances in the value of directly held stocks and home equity are less impactful than the savings gains and do not figure meaningfully into our view. We disagree with the widespread assumption that the increase in home prices is particularly notable. Per the Fed’s quarterly report on US financial accounts, the first quarter’s year-over-year increase in the value of real estate owned by households was 10.3%, a little more than half a standard deviation above the 275-quarter mean (Chart 11). It’s a nice gain, especially against a backdrop of low inflation, but it’s hardly a game changer. We agree that what goes up must come down, but in this case, reverting to the mean would only involve a three-percentage-point decline. Chart 11Housing Wealth Is Rising, But Not At An Outsized Rate Housing Wealth Is Rising, But Not At An Outsized Rate Housing Wealth Is Rising, But Not At An Outsized Rate It should also be noted that outright national declines in nominal home values are rare – the only incidence in the postwar era occurred amidst the subprime crisis/GFC. It appears that the trauma of that event has global investors and Google-searching US citizens overestimating the probability that it might occur again. We have exhumed the term “subprime crisis” because that housing bust was caused by a near-total abandonment of established lending standards by virtually everyone involved in mortgage origination and securitization, including the agencies that rated the securities, the middlemen who warehoused them, the end-investors who bought them and the insurer who blithely wrote credit protection on them. Nothing even remotely similar from a credit perspective is going on today. Chart 12 shows the aggregate loan-to-value (LTV) on residential mortgages since 1971, when the first baby boomers began to turn 25, derived from the Fed’s financial accounts data. Aggregate household LTV is back to the 33% level it hugged throughout the seventies and eighties. It exploded higher from 2006 to 2009 as new mortgage debt galloped ahead of stagnating home values during the lending crescendo of 2006 and 2007 and then continued on in 2008 and 2009 as mortgage balances fell more slowly than home values (Chart 13). Chart 12High LTVs Amplify Shocks, Low LTVs Absorb Them High LTVs Amplify Shocks, Low LTVs Absorb Them High LTVs Amplify Shocks, Low LTVs Absorb Them Chart 13Six Years That Crippled The Housing Market The US Housing Market: Déjà Vu All Over Again? The US Housing Market: Déjà Vu All Over Again? Appalling underwriting provided the kindling for the crisis and the unprecedented plunge in US home prices that was a feature of it. A similar plunge will not recur this cycle when there are almost no borrowers with little to no skin in the game who would walk away from their nonrecourse loans at the first sign of trouble. Psychology also matters; given our deep-seated aversion to recognizing losses, homeowners who do not have to sell often hold on until prices climb back above their basis. Home values will surely encounter some headwinds once mortgage rates rise from rock-bottom levels, but an outright decline remains unlikely when increases in longer-dated Treasury yields will almost certainly be accompanied by an increase in inflation and/or real growth expectations, both of which would be associated with higher home prices. We hold our conclusion with high conviction: the US housing market does not look vulnerable and it is not likely to be a source of distress for the financial system here or abroad.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the May 28, 2021 Global Fixed Income Strategy/Bank Credit Analyst Special Report, “Global House Prices: A New Threat For Policymakers.”

Highlights Entering 2H21, oil and metals' price volatility will rise as inventories are drawn down to cover physical supply deficits brought about by the re-opening of major economies ex-China. As demand increases and oil and metals supply become more inelastic, forward curves will backwardate further.  This will weaken commodity-price correlations with the USD and boost commodity-index returns. Going into next week's OPEC 2.0 meeting, the Kingdom of Saudi Arabia (KSA) and Russia likely will hold off on further production increases, until greater clarity around US-Iran negotiations and the return of Iran as a bona fide exporter is available. Chinese authorities will release 100k MT of copper, aluminum and zinc into tight domestic markets in July.  A two-day rally followed the news. Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, following the ~ 230% move in crude oil and the ~ 100% rise copper prices.  Higher volatility will present buying opportunities for these ETFs  (Chart of the Week). We remain long commodity index exposure – S&P GSCI and COMT ETF – expecting steeper backwardations. We will go long the PICK ETF at tonight's close again, after being stopped out last week with a 23.9% return. Feature Heading into 2H21, industrial commodity markets will continue to tighten.  In the case of oil, this is caused by OPEC 2.0's production-management strategy – i.e., keeping supply below demand – and capital discipline among producers in the price-taking cohort.1 Base metals, on the other hand, are tightening because demand is recovering much faster than supply.2 Re-opening of major economies will boost refined-product demand in oil markets – e.g., gasoline and jet fuel – which will leave refiners little choice but to continue drawing on inventories to cover supply shortfalls in the near term (Chart 2). Chart of the WeekResources ETFs Follow Prices Higher Resources ETFs Follow Prices Higher Resources ETFs Follow Prices Higher Chart 2Refiners Will Continue Drawing Crude Investments Refiners Will Continue Drawing Crude Investments Refiners Will Continue Drawing Crude Investments Base metals – particularly copper and aluminum – will remain well bid in the face of constrained supply and higher consumption ex-China.  Despite China's widely anticipated decision to release strategic stockpiles of copper, aluminum and zinc next month into a tight domestic market – which we flagged last month – continued inventory draws will be required to cover physical deficits in these markets, particularly in copper (Chart 3).3 Chart 3Copper Inventories Will Draw As Demand Ex-China Rises Copper Inventories Will Draw As Demand Ex-China Rises Copper Inventories Will Draw As Demand Ex-China Rises Chart 4Steeper Backwardation, Higher Volatility Oil, Metals Vol Creates Buying Opportunities Oil, Metals Vol Creates Buying Opportunities Higher Vol On The Way As demand for industrial commodities increases and inventories continue to draw, forward curves will become more backwardated – i.e., material delivered promptly (next day or next week) will command a higher price than commodities delivered next month or next year: Consumers value current supply above deferred supply, and producers and merchants have to charge more to cover inventory replacement costs, which increase when prompt demand outstrips supply. The steepening of forward curves for industrial commodities will lead to higher price volatility in oil and metals markets, particularly copper: Demand will confront increasingly inelastic supply.  In this evolution, prices will be forced to allocate inelastic supply as demand increases.  Sometimes-sharp changes in price are required to equilibrate available supply with demand when this happens.  This can be seen clearly in oil markets, but it holds true for all storable commodities (Chart 4).4 Investment Implications Industrial commodity markets are entering a more volatile phase, which will be characterized by sharp price movements up and down over the short term, as demand continues to outpace supply. Our analysis suggests this is the beginning of a more volatile phase in industrial commodity markets.  The balance of risk in industrial commodity prices will remain to the upside as volatility increases. In the short term, fundamental imbalances can be addressed over a relatively short months-long horizon – i.e., OPEC 2.0 can release spare capacity over a 3-4 month interval to accommodate rising demand – so that price increases do not destroy demand as oil-exporters are rebuilding their fiscal balance sheets. Base metals markets will have a tougher time in the short run finding the supply to meet surging demand, but it can be done over the next year or so without prices getting to the point where demand-destruction sets in. Over the medium to long term, investor-owned oil and gas producers literally are being directed by policymakers, shareholders and courts toward an extended wind-down of production and investment in future production.  Markets have been pricing through just such a situation in the post-COVID-19 world, with OPEC 2.0 managing supply against falling demand and still managing to reduce inventories significantly.  If the world follows the IEA's pathway to a decarbonized future – in which no investment in new oil or gas production is required after 2025 – this will become the status quo for these markets going forward.5 Metals producers, on the other hand, are being encouraged to increase marketable supply at a rapid pace to accommodate demand driven by the build-out of renewable energy – chiefly wind and solar – and the grids that will be required to move this energy. Producers, however, remain reluctant to do so, fearing their capex investment to build out supply will produce physical surpluses that depress returns, similar to the last China-led commodity super-cycle. Supplying the necessary base metals to make this happen will be difficult at best, according to Ivan Glasenberg, CEO at Glencore.  At this week's Qatar Economic Forum, he said copper supply will have to double between now and 2050 to meet expected demand for this critical metal.  “Today, the world consumes 30 million tonnes of copper per year and by the year 2050, following this trajectory, we’ve got to produce 60 million tonnes of copper per year,” he said.  “If you look at the historical past 10 years, we’ve only added 500,000 tonnes per year … Do we have the projects? I don’t think so. I think it will be extremely difficult.”6 The volatility we are expecting in oil, gas and base metals prices, will present buy-the-dip opportunities in related equities vehicles.  Since bottoming in March 2020, the XOP and XME ETFs covering oil and gas producers and metals miners are up ~ 218% and ~ 196%, respectively, matching the ~ 230% move in crude oil and the ~ 100% rise in copper prices.  We remain long commodity index exposure – S&P GSCI, which is up 5.9% and the COMT ETF, which is up 7.6% – expecting steeper backwardations.  The trailing stop on our MSCI Global Metals & Mining Producers ETF (PICK) position recommended 10 December 2020 was elected, which stopped us out with a gain of 23.9%.  We are getting long the PICK again at tonight's close.   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 Commercial crude oil stocks in the US (ex-SPR barrels) fell 7.6mm barrels w/w in the week ended 18 June 2021, according to the US EIA. Including products, US crude and product inventories were down 5.8mm barrels. US domestic crude oil production was down 100k b/d, ending the week at 11.1mm b/d. Overall product supplied, the EIA's proxy for refined-product demand, was up 180k b/d at 20.75mm b/d, which is 129k b/d below 2019 demand for the same period. At 9.44mm b/d, gasoline demand was just below comparable 2019 consumption of 9.47mm b/d, while jet-fuel demand remains severely depressed vs. comparable 2019 consumption at 1.58mm b/d (vs. 1.92mm b/d).  Distillate demand (e.g., diesel fuel) for the week ended 18 June 2021 was 3.95mm b/d vs. 3.97mm b/d for the comparable 2019 period. Base Metals: Bullish Benchmark spot iron ore (62% Fe) prices are holding above $210/MT in trading this week, as demand for the steel input remains strong in China (Chart 5). The Chinese Communist Party (CCP) increased its level of intervention in the iron ore market this week, launching investigations into “malicious speculation,” vowing to “severely punish” anyone found to be engaged in such behavior, according to ft.com.7 Benchmark iron ore prices hit $230/MT in May. We continue to expect exports from Brazil to pick up in 2H21, which will push prices lower in 2H21. Precious Metals: Bullish In the aftermath of last Wednesday’s FOMC meeting gold prices lost nearly $86/oz (Chart 6). Our colleagues at BCA Research's USBS believe markets are paying too much attention to the Fed’s dot plots, and not to the central bank’s verbal guidance.8 Originally, the Fed stated that it will only start raising interest rates once a checklist of three conditions have been met. This checklist includes guidance on actual and expected inflation rates and the labor market. Gold prices did not react to Chair Powell's testimony before the House Select Subcommittee on the Coronavirus Crisis. Ags/Softs: Neutral US spring wheat prices are rallying on the back of dry weather in the northern Plains, while forecasts for benign crop weather in the Midwest pressured soybeans lower this week, according to successfulfarming.com. Chart 5 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN Chart 6 US Dollar To Keep Gold Prices Well Bid US Dollar To Keep Gold Prices Well Bid     Footnotes 1     Please see our most recent oil price forecasts published last week in Balance Of Risks Tilts To Higher Oil Prices.  It is available at ces.bcaresearch.com. 2     Please see A Perfect Energy Storm On The Way published on June 3, 2021 for further discussion. 3    Please see Less Metal, More Jawboning published on May 27, 2021, which flagged China's likely decision to release strategic stockpiles of base metals. 4    Chart 4 shows implied volatility as a function of the slope of the forward curve, i.e., the difference between the 1st- and 13th-nearby futures divided by the 1st-nearby future vs implied volatilities for Brent and WTI options.  This modeling extends Kogan et al (2009), mapping realized volatilities calculated using historical settlements of crude oil futures against the slope of crude oil futures conditioned on 6th- vs. 3rd-nearby futures returns (in %). Please see Kogan, L., Livdan, D., & Yaron, A. (2009), "Oil Futures Prices in a Production Economy With Investment Constraints." The Journal of Finance, 64:3, pp. 1345-1375. 5    Please see fn 2's discussion of the IEA's Net Zero by 2050, A Roadmap for the Global Energy Sector beginning on p. 5 under The Case For A Carbon Tax. 6    Please see Copper supply needs to double by 2050, Glencore CEO says published on June 23, 2021 by reuters.com.  Of course, being a copper producer with large-scale base-metals projects due to come on line in the next year or so, Mr. Glasenberg could be talking his book, but as Chart 3 shows, copper has been and likely will be in physical deficits for years. 7     Please see China cracks down on iron ore market, published by ft.com on June 21, 2021. 8    Please see How To Re-Shape The Yield Curve Without Really Trying, published on June 22, 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights Economy – Following a recession like no other, American households are flush with cash: Since COVID-19 broke out last March, real disposable income has grown at its fastest 14-month rate ever, the S&P 500 is 24% above its pre-pandemic peak and home prices are up 14%. With social distancing measures hindering consumption as income rose, savings have exploded. Markets – If the cash is spent in line with economists’ expectations, corporate profits should have little trouble topping undemanding targets: The bottom-up consensus forecast for nominal earnings contraction over the rest of the year is incompatible with real GDP growth forecasts of nearly 7%. Strategy – Stick with equities unless the Fed changes its tune: Multiple contraction looms as the main threat to equities over the next twelve months, and a shift in Fed policy is the most likely de-rating catalyst. As long as Powell and company stay the course, we will too. Feature BCA researchers’ mission is simple. We analyze the world’s major economies for insight into where financial markets are headed. On the US Investment Strategy team, we primarily use the US economy to anticipate the future direction of US equity and bond markets. Our market take drives our investment strategy views and asset allocation recommendations. With this Strategy Report, we are tweaking the format of our written output to align more clearly with our mission. We will highlight the most relevant economic takeaways and link them to expected market outcomes, with our strategy recommendations following from the forecasted outcomes. To provide more detail than US Investment Strategy’s legacy overweight/equal weight/underweight asset allocation recommendations, we will add a multi-asset ETF portfolio linking our cyclical views to specific ticker symbols. We are at work on our cyclical portfolio and will unveil it sometime over the next month. One Fantastic Recession If a visitor from space had touched down at the beginning of 2020 and spent the subsequent seventeen months boarding in an American household, he/she/they might ask why recessions have gotten such a bad rap. Savings piled up as fiscal transfers swelled household income while social distancing measures curtailed spending. Wealth got an additional boost from surging stock and bond markets and a potent rally in home prices. Put it all together, and households are on much firmer footing today than they were when the pandemic began to assert itself last March. As a first-time visitor, the space traveler may not appreciate that the pandemic recession was sui generis thanks to the unprecedented policy measures undertaken to limit its damage. For the first time in 51 years (seven recessions ago), the rate of nominal disposable income growth accelerated during a recession (Chart 1). In real terms, the pandemic period has been the best fourteen-month stretch for disposable income growth in the 70-year history of the series, reaching a level three standard deviations above the mean (Chart 2). Lavish fiscal transfers in the form of direct payments to over three-quarters of all households (Chart 3, top panel) and supplemental benefits to the unemployed (Chart 3, middle panel) cushioned the blow that would typically result from economic contraction and soaring unemployment. Chart 1Uncharacteristic Growth In Nominal Income ... Uncharacteristic Growth In Nominal Income ... Uncharacteristic Growth In Nominal Income ... Chart 2... And Unprecedented Growth In Real Income ... And Unprecedented Growth In Real Income ... And Unprecedented Growth In Real Income Chart 3No Adult Left Behind A Recession Like No Other A Recession Like No Other So far, the consequence of the policy measures has been to limit the decline in output (real 4Q20 GDP was 2.4% below its 4Q19 level, or about 4.4% below trend) and stave off a self-reinforcing wave of defaults that would have limited credit availability and hampered future growth. Going forward, the potential for households to spend some of the $2.3 trillion mountain of excess savings they’ve accumulated since March 2020 (Table 1) should turbo-charge growth across the rest of the year and keep it well above trend in 2022. Excess pandemic savings will be the primary spending driver, but equity gains (Chart 4, top panel) and home price appreciation (Chart 4, bottom panel) will help at the margin. All in all, savings and increases in financial asset and real property prices have driven an unprecedentedly rapid increase in household net worth as a share of GDP (Chart 5), feeding a remarkable buildup of dry powder to support a surge in consumption. Table 1A Great Recession For Household Savings ... A Recession Like No Other A Recession Like No Other Chart 4The Recession That Was Good For Asset Prices The Recession That Was Good For Asset Prices The Recession That Was Good For Asset Prices Chart 5The Pandemic Recession Did Wonders For Households' Relative Standing The Pandemic Recession Did Wonders For Households' Relative Standing The Pandemic Recession Did Wonders For Households' Relative Standing What Does GDP Growth Have To Do With Equity Returns? There’s a good reason why Treasury investors pay much more attention to GDP releases than equity analysts and PMs: S&P 500 returns have no near-term relationship with GDP moves. Corporate revenue growth ought to converge with the economy’s nominal growth rate over time, however, so future GDP moves could inform the future direction of S&P 500 earnings. With all the fuel households have stored up for consumption once the economy fully reopens, consensus forecasts are calling for blockbuster growth over the final three quarters of the year and solidly above-trend growth in 2022 (Table 2). Though BCA does not make economic point forecasts, we concur with the direction and magnitude of the consensus view. The top-down forecast of red-hot economic growth is seemingly incompatible with bottom-up analysts’ consensus forecast of a decline in the run rate of S&P 500 earnings. With 495 constituents having reported, calendar first quarter S&P 500 earnings are projected to come in at $49 per share. Absent seasonal adjustments, $49 equates to an annualized run rate of $196 per share. Analysts are calling for a nearly 10% sequential decline in earnings in the second quarter, to $44.49, third quarter earnings that fall about 4% shy of their first quarter level, and meager 1% and 2% increases over 1Q21 in 4Q21 and 1Q22, respectively (Table 3). Table 2Economists Predict Explosive GDP Growth ... A Recession Like No Other A Recession Like No Other Table 3... But Analysts Foresee Declining Earnings ... A Recession Like No Other A Recession Like No Other   The key takeaway is that analysts expect the sum of the next four quarters of S&P 500 earnings to fall short of the first quarter’s annualized run rate. That is an unusual development in a series that has averaged double-digit expected forward growth over its 42-year life and had previously only called for earnings to shrink on three instances during the Carter Administration (Chart 6). We are in accord with widely held expectations that the economy’s sequential growth rate will peak in the second quarter and fully expect that sequential earnings growth will decelerate from the last three quarters’ torrid pace. Outright contraction, however, strikes us as highly unlikely when the economy is growing at the fastest sustained rate we expect to see over the rest of our lifetime. Chart 6... For The First Time In Four Decades ... For The First Time In Four Decades ... For The First Time In Four Decades Investment Strategy We view equity prices as the product of expected earnings and the multiple investors will pay for those earnings. Holding the index price-earnings (P/E) multiple constant, the S&P 500 will rise if earnings beat expectations and that beat feeds into upward revisions in future estimates or fall if they disappoint, leading to downward revisions. We expect that the S&P’s constituents will beat current expectations over the next four quarters, which simply require them to run in place. Earnings growth should not be too hard to come by when the economy is expected to expand at a 7% pace – three-and-a-half times its trend rate of growth – over the rest of 2021. That leaves the multiple investors are willing to pay for those future earnings as the swing factor. If earnings are the stolid fundamental component of equity investing, P/E multiples are the animal-spirits wild card. The current 22 multiple is expensive relative to history and potential de-rating is the biggest risk confronting equity investors (Chart 7). Chart 7Equity Multiples Are Elevated Equity Multiples Are Elevated Equity Multiples Are Elevated The key question is what will trigger a de-rating and when. We expect that monetary policy tightening will be the most likely catalyst and are therefore keeping a close eye on the Fed as we formulate our strategy. Our US Bond Strategy colleagues have stressed that the Fed will not hike rates until all three of its criteria (Table 4) are met. With the economy seemingly much closer to checking the inflation boxes, “maximum employment” is poised to be the final hurdle standing in the way of rate hikes. Table 4A Checklist For Liftoff A Recession Like No Other A Recession Like No Other We did not view the May employment situation report, released before Friday’s open, as materially changing the timeframe for attaining maximum employment. Though bond, currency and equity markets saw the approximate 100,000 March-May payrolls miss as a cue to reprice their Fed assumptions, the report fit the broad contours that we expect to remain in place over the next year: the labor market will revive as the services sector fully reopens and the restoration of child care and elder care services free those sidelined by family obligations to return to work. There are still more than 7.5 million fewer people working than there were before the pandemic (Chart 8). If payrolls expand at an average monthly clip of 500 to 750 thousand, employment progress will support tapering in the winter of 2021-22 and an initial rate hike before the end of 2022. Chart 8Still 7.6 Million People To Re-employ Still 7.6 Million People To Re-employ Still 7.6 Million People To Re-employ We do not see the sure-to-be-well-telegraphed tapering of the Fed’s asset purchases as posing a threat to equity multiples. Our first-hike-in-2022 timetable is ahead of the market’s but we do not expect meaningful de-rating over the next twelve months while investors of every stripe are stuffed with cash. If the rate-hike timetable accelerates because of unexpectedly strong growth, S&P 500 earnings estimates will have to rise to reflect it. We would expect that “numerator effect” to fully offset increases in the discount rate denominator used to the calculate the present value of expected future cash flows, as periods of rising real rates have typically been associated with better equity performance than periods of falling real rates.1 Equities would be in trouble if rates were to take off because of runaway inflation expectations rather than rising real growth. In that scenario, the future-cash-flows numerator would not be able to keep up with the rising-discount-rate denominator and it could even fall outright as profit margins were squeezed. We are continuously monitoring our inflation checklist and are vigilant for signs of enduring inflation pressures. The bottom line is that the potential emergence of inflation pressures, and the Fed’s reaction to them, are the biggest imminent threat to forward earnings multiples and equity performance. As long as the inflation coast is clear and the Fed is able to stand pat, abiding by last summer’s revised statement of long-run policy goals, we will stick with our equity overweight. Postcard From The High Street The Harry Potter store filling 20,000 square feet of retail space between Broadway and Fifth Avenue just below 22nd Street had its grand opening on Thursday. The Peta children’s attempt to visit the store on its first day came to no avail, however, as they encountered late-afternoon switchback lines around the building. Scattered showers were not enough to dampen would-be shoppers’ enthusiasm, some of whom claimed to have been waiting for six hours.2 The event highlighted two themes from last week’s Special Report: brick-and-mortar retail has not yet given up the ghost and the post-COVID period in the United States, marked by a desire to congregate, celebrate and spend, appears to have arrived. The near-term growth implications are favorable. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see US Investment Strategy Special Report "When Will Higher Rates Hurt Stocks?" dated September 24, 2018, available at usis.bcaresearch.com 2 Harry Potter fans wait hours in the rain for NYC store opening (nypost.com)

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Norway's Vaccination Progress Norway's Vaccination Progress Chart 2Mobility Will Pick Up Mobility Will Pick Up Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well The Norwegian Method The Norwegian Method Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Positive Household Fundamentals Positive Household Fundamentals Chart 6Consumption Will Improve Further Consumption Will Improve Further Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The Norwegian Method The Norwegian Method The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Capital Spending Is Important For Norway Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 The Norwegian Method The Norwegian Method Chart 12Gas Production Is Rising In Importance The Norwegian Method The Norwegian Method Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation The Norwegian Method The Norwegian Method Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last The Norwegian Method The Norwegian Method According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Norwegian Method The Norwegian Method The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I The Dutch Disease, Part I The Dutch Disease, Part I Chart 23The Dutch Disease, Part II The Dutch Disease, Part II The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency NOK Is A Procyclical Currency NOK Is A Procyclical Currency Chart 26NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown The Norwegian Method The Norwegian Method That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Oslo Beats New York Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Favor Norway Over The Euro Area Favor Norway Over The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021.

Highlights The Norwegian economy will continue to grow above trend for the next two years or so. Norwegian inflation will firm up. Among Advanced Economies, the Norges Bank will lead the way in terms of policy tightening; however, money markets already embed this view. Nonetheless, the Norwegian krone remains an appealing value play, a result of its pronounced pro-cyclicality. USD/NOK and EUR/NOK will depreciate over the next 24 months. Norwegian equities face structural headwinds, but they should outperform their US and Euro Area counterparts. However, Norwegian stocks will lag behind Swedish equities. Buy Norwegian stocks / sell Dutch ones. Feature Norway remains an example of how to handle the pandemic successfully. Since the onset of the COVID-19 crisis, Norway has registered the lowest rate of infections per capita, in part aided by its early decision to close its borders. Fiscal stimulus was prompt and finely tailored to the sectors most in need of emergency funds. Moreover, the Norges Bank cut interest rates to zero for the first time since its founding in 1816. As nations across the world coordinated monetary and fiscal accommodation during the pandemic, Nordic economies had already mastered this paradigm. Thus, counter-cyclical buffers worked like a charm in Norway. For example, the contraction in Norwegian GDP was the most subdued within the G10, and the recovery is also impressive. Today, Norwegian GDP is 2% above pre-pandemic levels, inflation is near the target rate of 2%, and the central bank will be among the first to lift interest rates. In this Special Report, we explore whether or not conditions remain ripe for strong performances by both Norwegian equities and the NOK. In our view, the global environment and the continued economic strength of Norway will create potent tailwind for Norwegian assets over the coming two years or so. A Robust Economic Outlook The Norwegian economy is set to continue growing at a robust above-trend pace and inflation will remain above the Norges Bank’s target. The Pandemic Norway has moved largely beyond the COVID-19 pandemic. The number of cases per 100 is a mere 2, which compares favorably to the US at 10, Germany at 4, France at 8, or its neighbor Sweden at 10. Norway closed its borders on March 12, 2020, to limit the entry of the virus on its territory, as health authorities opted for rapid containment measures. As a direct result of these policies, Norwegian consumers and workers gained greater peace of mind in their day-to-day dealings, and economic activity recovered rapidly. This process led to Norway’s GDP contracting by only 4.6% in Q2 2020, which compares favorably to contractions of 19.5% in the UK, 9.7% in Germany and 7.8% in Sweden. Norway’s vaccination campaign is also gaining momentum. At first, the country’s inoculation performance lagged. However, Norwegian procurement of vaccines has improved, and the pace of inoculation is accelerating (Chart 1, top panel). The result is that the share of the population that is fully vaccinated is inching toward 20% and accelerating. Authorities expect greater relaxation of containment measures this summer, which will allow mobility to improve (Chart 2). The local service sector will therefore receive a welcome fillip. Chart 1Norway's Vaccination Progress Norway's Vaccination Progress Norway's Vaccination Progress Chart 2Mobility Will Pick Up Mobility Will Pick Up Mobility Will Pick Up   Fiscal Policy Fiscal policy remains an important complement to national health directives. During the crisis, the fiscal deficit reached 3.4% of GDP, which generated a fiscal thrust of 6% of GDP. Moreover, the drawdown from the Norwegian Oil Fund amounted to 12.5% of GDP. These provided targeted supports to industries, such as tourism and transport, while a furlough scheme protected household income. Thus, these programs effectively alleviated the pain on the sectors of the economy most affected by the pandemic. Going forward, Norway will also suffer from one of the smallest fiscal drag in the G10 for the remainder of 2021 and 2022 (Chart 3). Chart 3Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop Norway's Advantageous Fiscal Backdrop The Banking System The credit channel in Norway remains open and fluid, as a resilient banking system withstood the economic fallout from the pandemic. According to the Norges Bank, credit losses have been limited; they peaked at 1% of lending and are already declining. Additionally, banks have restricted exposure to the sectors hardest hit by the pandemic, such as travel and tourism, personal services, and transport (Chart 4). Moreover, the profitability of the banking system decreased, as global yields fell last year, but RoE remains around 10% and net interest margins hover near 2.5% and 1.5% for non-financial corporate loans and households lending, respectively. Crucially, the Norwegian banking system sports a regulatory Tier-1 capital-to-risk weighted-assets ratio of 20%, well above Basel III criteria or that of the Eurozone banks (Chart 4, bottom panel). Chart 4Norwegian Banks Are Faring Well The Norwegian Method The Norwegian Method Household Consumption Household consumption will remain a source of strength over the coming quarters. Household net worth is growing robustly as a result of the rapid appreciation of house prices across the country (Chart 5, top panel). Moreover, the share of debt held by households with a high debt-to-income ratio or a low debt-servicing capacity remains low, which suggests household balance sheets are firming (Chart 5, middle panel). Employment is also recovering well. After peaking at 9.5% in March 2020, the headline unemployment rate fell to 3.3% last month (Chart 5, bottom panel). Meanwhile, the number of employed workers bottomed in July 2020 and has been steadily recovering ever since. The only blemish is that, as of Q4 2020, the rate of underemployment among the prime-age population remains at 3.5%, which is somewhat elevated by national standards. This balance sheet and employment backdrop confirms the Norges Bank’s projection: the household savings rate will decline significantly over the coming two years (Chart 6, top panel). Hence, the marked pick-up in consumer confidence should translate into a major recovery in real consumption growth (Chart 6, bottom panel). Nonetheless, the service sector will likely be the main beneficiary of this improvement, as real retail sales are already well above their historical trend Chart 5Positive Household Fundamentals Positive Household Fundamentals Positive Household Fundamentals Chart 6Consumption Will Improve Further Consumption Will Improve Further Consumption Will Improve Further   Net Exports Chart 7Years Of Underinvestment In Oil & Gas The Norwegian Method The Norwegian Method The external sector will create another tailwind for the Norwegian economy. Prior to the pandemic, 71% of Norway’s exports flowed to Europe. Moreover, oil and gas represented 53% of shipments, and cyclically sensitive exports amounted to 74% of total or 24% of GDP. Thus, even if China’s economy slows, Europe’s economic re-opening will raise the Norwegian trade balance, which sits near a multi-decade low.1 Moreover, greater mobility in Europe and around the world will elevate demand for petroleum. In light of the tepid pace of investment in global oil and gas extraction over the past five years, our commodity strategists forecast further oil and gas price appreciation2 (Chart 7), which will boost Norway’s terms of trade. The national income will therefore expand smartly, especially because oil and gas shipments will increase thanks to growing production from the new Johan Sverdrup field. Capital Spending This context suggests that capital spending, which accounts for 26% of Norway’s output (Chart 8), will constitute an important tailwind to domestic activity. Capex is even more important to the Norwegian economy than it is for other Nordic economies or even Germany (Chart 9). Chart 8Capital Spending Is Important For Norway Capital Spending Is Important For Norway Capital Spending Is Important For Norway Chart 9The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway The Capex Share Of GDP Is Higher In Norway Norwegian capex is highly cyclical. Capital formation tracks our BCA Global Nowcast indicator (a combination of high-frequency economic and financial variables that proxy the global industrial cycle), as well as the domestic manufacturing PMI. These indicators suggest that capex should increase by 10-15% in the coming quarters (Chart 10). A Norges Bank survey of capex intentions, which are firming, corroborates this view. Chart 10Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover Capex Will Recover Strongly Capex Will Recover On the energy front, the new Johan Sverdrup oil and gas discovery marks a major turnaround in capital spending for Norway. According to the Norges Bank, real petroleum investment will increase from approximately NOK 175bn in 2021 to NOK 198bn by 2024 (Chart 11). Moreover, years of global underinvestment in oil extraction suggests Norway will gain market share in exports as production accelerates. Total petroleum production is slated to increase by 10% over the next 4 years. More importantly, by 2025, over 50% of production from Norwegian oil fields will be natural gas and associated liquids (Chart 12). Demand for natural gas and NGLs will be more inelastic than demand for crude because the latter is threatened by the rising electrification of vehicles, while the former faces more sustainable demand as China, among others, moves to replace its coal polluting plants with cleaner alternatives. Chart 11Real Petroleum Investment Will Increase By 13% In 2024 The Norwegian Method The Norwegian Method Chart 12Gas Production Is Rising In Importance The Norwegian Method The Norwegian Method Inflation This positive economic outlook suggests that Norwegian inflation will remain above the central bank’s target of 2%. Already, headline CPI stands at 3%. Meanwhile, core inflation is at 2%, but it is decelerating. However, this slowdown should be temporary. According to a Norges Bank survey, both long-term and near-term inflation expectations among economists, business leaders, and households are rising, which indicates that a deflationary mentality has not taken root in Norway. Moreover, wage expectations have quickly normalized following the trauma of 2020 (Chart 13). Capacity constraints further reinforce the notion that inflation has upside. The Norges Bank Regional Network survey shows that capacity and labor supply constraints are tighter than they were in the 2014 to 2017 period, when inflation averaged 2.3% and the policy rate fell to 0.5% (Chart 14). Moreover, according to the same survey, selling prices are also stronger than they were during the 2016 oil collapse (Chart 14, bottom panel) Chart 13No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality No Signs Of A Deflation Mentality Chart 14Capacity Doesn’t Point To Falling Inflation The Norwegian Method The Norwegian Method Bottom Line: The Norwegian economy will continue to grow above its trend rate of 1.5%, at least through to 2022. The acceleration in vaccination numbers will allow a reopening of the economy, while the fiscal drag will be limited and the banking system remains resilient. The outlook for households remains positive and employment is firming, which will lead to stronger consumption. Meanwhile, exports and capex have significant upside ahead. As a result, we anticipate Norwegian inflation will remain above target for the foreseeable future. The Norges Bank Will Lead The Pack The Norges Bank’s response to the pandemic was swift and all encompassing: It cut interest rates in the spring of 2020 from 1.5% to zero, the lowest level since the formation of the bank in 1816. It set up extraordinary F-loans at very generous interest rates, to provide ample liquidity to commercial banks. The longest maturity loan of 12 months had a prevailing interest rate of just 30 basis points. It also relaxed collateral requirements for these loans. It introduced swap lines with the Federal Reserve to provide US dollar funding to Norwegian firms. Since then, our Norges Bank monitor has rebounded powerfully from very depressed levels, which suggests that emergency policy settings have become unnecessary. Moreover, the Norwegian Central Bank Monitor towers above that of other G10 countries, which indicates that the Norges Bank should lead the pack in normalizing policy rates (Chart 15). Chart 15The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle The Norges Bank Should Lead The Tightening Cycle Chart 16The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The Growth Component Of Our Monitor Has Exploded Higher The biggest improvement in our Norges Bank Monitor comes from its growth component, which has surged to its highest levels in over two decades. This improvement surpasses those that followed the global financial crisis and the burst of the dot-com bubble (Chart 16). In essence, the growth component of the Monitor signals that the Norwegian economy has achieved escape velocity. Norway’s robust economic turnover is increasing the velocity of money, which points to the need for higher interest rates. Money velocity can be regarded as the equilibrating mechanism between money supply and nominal output, from the classical Fisher equation MV=PQ (where M is the money supply, P is prices, Q is real output, and V is money velocity). Thus, rising money velocity (when PQ expands faster than M) signifies that the economy needs higher interest rates to encourage savings. In Norway’s case, the velocity of money is surging through 2021, which confirms that the Norges Bank may depart from its current emergency policy setting (Chart 17). Chart 17Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway Money Velocity Is Rising In Norway The OIS curve already reflects this reality. At the last central bank meeting in March, Governor Øystein Olsen stated that interest rates would increase in the second half of this year. Already, the central bank’s balance sheet has been expanding more slowly than that of its peers (Chart 18). In response to this messaging, investors now expect the Norges Bank to lead the Fed, ECB, Riksbank, and BoE in lifting interest rates (Chart 19). Chart 18The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over The Norges Bank's Balance Sheet Impulse Has Rolled Over Chart 19Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First Money Markets Already Expect The Norges Bank To Tighten First The Norges Bank must nonetheless manage a tough balancing act. Lifting rates too soon or too fast could torpedo the recovery, if the currency and bond yields increase too rapidly and tighten financial conditions in a disruptive fashion. However, not removing accommodation fast enough could lead to economic overheating. Bottom Line: The Norges Bank will be the first DM central bank to increase interest rates, most likely as soon as this September. The OIS curve already reflects this outlook; it prices in over 6 hikes by the end of 2023, more than any other DM money market curve. This pricing seems appropriate; thus, Norwegian money markets offer no compelling investment opportunity.  Norway’s Problem: Sagging Productivity Both the OECD and the IMF view weak productivity growth as Norway’s biggest long-term hurdle. Despite the bright economic outlook for the next two years or so, we agree. Since 2004-2005, Norwegian productivity has sharply decelerated. At the turn of the millennium, the Norwegian’s mainland labor productivity was growing at 2.5%, or a percentage point above the average of the OECD. Today, labor productivity growth is a paltry 0.5%, placing Norway last among Nordic economies (Chart 20, left panel). Total factor productivity tells a similar story. After recording the fastest productivity expansion among G10 nation from 1990 to 2005, Norway’s TFP declined 11% and is now situated at the same level as it was in 1995. This deterioration is comparable to Italy’s TFP (Chart 20, left panel). Chart 20From Best To Last The Norwegian Method The Norwegian Method According to the most recent OECD country report, one of the roots of Norway’s productivity problem is an absence of low-hanging fruit. Norway sports one of the highest GDP per hours worked in the world. This nation essentially sits near the global productivity frontier. Its product market regulations are generally not onerous (Chart 21, top panel). Likewise, more than 60% of both the service sector and the manufacturing sector’s workforce use ICT tools, which is at the highest level among OECD countries. Additionally, the jobs at risk of a negative impact from automation or technological changes represent a significantly smaller share of total employment than in most OECD nations (Chart 21, bottom panel). Chart 21Doing Things Right The Norwegian Method The Norwegian Method The Dutch Disease, the hollowing out of the manufacturing sector due to a capital hungry resource sector, is the second root of Norway’s productivity problem. Historically and across countries, manufacturing is the sector that records the greatest productivity gains. However, since 1979, the oil and gas and the housing sectors have experienced the largest capital investments expansion in Norway. Meanwhile, the share of capex generated by the manufacturing sector has declined to a paltry 5% (Chart 22). Moreover, oil and gas represents a larger share of capex than the contribution of its gross value added to GDP. The same holds true for housing, whose share of capex doubled over the past 27 years. Meanwhile, manufacturing’s share of capex has consistently lagged its representation in GDP, which has steadily declined (Chart 23). These are the typical symptoms of the Dutch Disease; as long as oil prices remain in a secular decline, any cyclical improvement in productivity will prove to be transitory. Chart 22The Dutch Disease, Part I The Dutch Disease, Part I The Dutch Disease, Part I Chart 23The Dutch Disease, Part II The Dutch Disease, Part II The Dutch Disease, Part II Bottom Line: Despite an upbeat cyclical outlook, Norway’s deteriorating productivity trend constitutes a formidable structural headwind. There are no easy solutions, because Norway already sits near the global productivity frontier. Moreover, Norway suffers from a pronounced case of the Dutch Disease. For decades, the oil and gas sector has absorbed a share of capital that is greater than its role in the economy, starving the productivity-generating manufacturing sector from investments. With the oil sector entering a structural decline due to ESG concerns, this trend will not change without a significant change in the allocation of the Norwegian capital stock. Investment Implications The cyclical outlook (12 to 24 months) for the Norwegian currency and stock market remains appealing. The NOK’s Outlook Chart 24The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis The Krone Is Undervalued On A PPP Basis While money markets do not offer any compelling opportunities to play the Norges Bank’s hiking cycle, the krone remains attractive from a cyclical perspective. Over the next 12-18 months, the NOK should appreciate compared to both the US dollar and the euro on the back of four key pillars. On a purchasing power parity basis, the Norwegian krone is undervalued by 14%. This compares favorably with both the euro, which is undervalued by 12%, and the US dollar, which is overvalued by 12% (Chart 24). More importantly, our PPP model adjusts the consumption basket across countries, allowing for a more apples-to-apples comparison. The Norwegian krone is highly procyclical and will benefit from any improvement in the global backdrop. The performance of NOK/USD, NOK/EUR, and NOK/JPY moves in lockstep with global equities (Chart 25). Norwegian equities have greatly underperformed global bourses over the last decade, but, as we argue below, there is some room for mean reversion. Inflows into the Norwegian equity market should benefit the krone (Chart 26). Chart 25NOK Is A Procyclical ##br##Currency NOK Is A Procyclical Currency NOK Is A Procyclical Currency Chart 26NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares NOK Moves With A Rerating In Norwegian Shares From a more fundamental perspective, the krone will benefit from positive income flows, given Norway’s large net international investment position (NIIP). In fact, ever since the first Norwegian oil fields began producing light sweet crude in the North Sea in the 1970s, Norway has maintained a structural trade surplus with most of its trading partners. This has allowed the country to build one of the biggest NIIP in the world (Chart 27), trailing only behind Hong Kong and Singapore. This large NIIP generates large income receipts that skew heavily toward equity dividends. This characteristic of the Norwegian balance of payment strengthens the bond between the NOK and global equities. Over the next few years, Norway’s trade balance should also get a boost, not only from rising oil and gas production, but also from an improvement in terms of trade, as we argued above. The trade balance has historically been the biggest driver of cross-border inflows into Norway, and that should remain positive for the basic balance and the NOK (Chart 28) Chart 28Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Norway's Basic Balance Should Improve Norway Balance Of Payments Chart 27Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position Norway Has A Large Net International Investment Position On a structural basis, however, the Norwegian krone faces challenges. Declining productivity suggests that economic growth in Norway will be more inflationary. This will lower the fair value of the real exchange rate. Therefore, while we are positive on the NOK over the next 18 to 24 months, we will be cognizant not to overstay our welcome. Finally, as for NOK/SEK, the pair should rise as both oil and gas prices remain firm in the near term, but any structural challenges to both oil and/or Norwegian productivity will favor the SEK over the longer term (Chart 29).    Chart 29NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices NOK/SEK Will Track Crude Prices The Equity Market Outlook Norwegian equities remain challenged as long-term holdings, but they are attractive on a cyclical basis. The poor profitability of Norwegian equities is their main long-term problem. Unlike Swedish stocks, Norwegian shares sport a return on equity in line with that of the Eurozone, not that of the US. Norway’s profit margins are weak and its asset turnover rivals that of the Euro Area (Chart 30). Additionally, the country’s poor productivity performance argues against a sudden reversal in RoEs. Chart 30Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Norway Is More Like The Eurozone Than Swden Sectoral composition creates another structural handicap for the Norwegian market. Oslo overweighs Energy and Financials (Table 1). Energy stocks can experience periodic rallies, but their long-term outlook is bleak in a world moving away from carbon-based power. Meanwhile, financials are also likely to remain structural laggards. The regulatory legacy of the Great Financial Crisis has curtailed leverage, which is depressing the RoE of the banking sector. Greater competition and the emergence of the fintech industry are further undermining fee income. None of these factors will change anytime soon. Table 1Sectoral Breakdown The Norwegian Method The Norwegian Method That being said, Norwegian equities remain a compelling opportunity for the next two years or so, despite their long-term problems. Norwegian stocks have an extremely negative beta to the US dollar. The historical sensitivity of the NOK to the USD in part explains this attribute, the other part being their elevated cyclicality. The dollar is one of the most counter-cyclical currencies in the world; thus, its weakness correlates with strong Norwegian forward earnings, which are heavily influenced by commodity prices and the global industrial cycle. This process also lifts Norwegian stock prices (Chart 31). Hence, BCA’s positive outlook on the global business cycle, as well as our negative stance on the dollar, points to significantly stronger Norwegian share prices.3 The slowdown in China’s economy is one risk that could cause some near-term tremors in Norwegian assets, which investors should use to build positions. In response to Beijing’s efforts to limit systemic risk, the Chinese credit impulse has slowed from 1.1% of GDP to 0.3%, and could flirt with the zero line. The ensuing investment slowdown will weigh on the global industrial sector and cause a temporary pullback in commodity prices. As Chart 32 illustrates, this will be negative for Norwegian equities; historically, following declines in Chinese yields, Norwegian forward earnings and stock prices weaken. However, global energy demand will remain robust even as China slows; therefore, correcting Norwegian equities create a buying opportunity. Chart 31Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Norwegian Stocks Are A Dollar-Bearish Bet Chart 32A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk A Chinese Slowdown Is A Risk Norwegian stocks should also outperform US and Eurozone equities. Nonetheless, Norwegian equities enjoy their greatest appeal against the US benchmark. Norwegian stocks trade at valuation discounts ranging from 38% to 54% compared to their US counterparts. Meanwhile, Norway’s net earnings revisions remain depressed compared to the US. Most importantly, Norwegian stocks are more pro-cyclical and sensitive to EM and global financial conditions than US shares are. Consequently, Oslo outperforms New York when the broad trade-weighted dollar depreciates, EM currencies appreciate, and the global yield curve slope steepens (Chart 33). We expect these trends to intensify over the remainder of the business cycle. Chart 33Oslo Beats New York Oslo Beats New York Oslo Beats New York Norwegian equities are also more responsive than Eurozone equities to global business-cycle oscillations. Norwegian equities outperform those of the Eurozone when the dollar depreciates (Chart 34). Additionally, a simple modelling exercise reveals that rising oil prices and global yields result in higher relative share prices in favor of Norway (Chart 35). Chart 34Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Norway Outperforms The Eurozone When The Dollar Weakens Chart 35Favor Norway Over ##br##The Euro Area Favor Norway Over The Euro Area Favor Norway Over The Euro Area Sweden is the one market that maintains a hedge over Norway.4 Swedish stocks not only sport a RoE nine percentage point above that of Norway, they are also sensitive to the global business cycle. However, the main advantage of Swedish equities is their sectoral breakdown. Sweden has an enormous overweight in industrials (38% of the benchmark), while Norway greatly overweighs materials. In an environment in which China is likely to decelerate, but global capex and infrastructure spending will remain firm, Sweden’s industrials’ weighting gives it a powerful advantage over its neighbor’s stock market. Finally, we recommend the following high-octane trade: Long Norwegian / short Dutch stocks. The Amsterdam bourse has a 47% allocation to tech stocks and a greater “growth” bias than the S&P 500. This means that the relative performance of Norwegian stocks compared to Dutch equities is even more sensitive to the global business cycle, oil prices, and bond yields. As a result, our simple model incorporating both Brent prices and yields currently sends a strong buy signal in favor of Norway (Chart 36). Chart 36Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Time To Buy Norway And Sell The Netherlands Bottom Line: The NOK will perform strongly against both the USD and the EUR over the coming 18 to 24 months. Norwegian equities are not an appealing long-term bet; however, they will experience significant upside over the coming two years, both in absolute terms and relative to the US and Euro Area stocks. While Oslo is unlikely to outperform Stockholm over this period, we recommend buying Norwegian stocks and selling the Dutch index. Mathieu Savary Chief European Investment Strategist Mathieu@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see European Investment Strategy Report, "A Surprising Dance," dated May 10, 2021. 2 Please see Commodity & Energy Strategy Report, "OPEC’s 2.0 Production Strategy In Focus," dated May 20, 2021. 3 Please see Foreign Exchange Strategy Report, "Explaining Recent Weakness In The US Dollar," dated May 14, 2021. 4 Please see European Investment Strategy Report, "Take A Chance On Sweden," dated May 03, 2021. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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 A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way 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 OPEC 2.0s Could Expand If Investor Activism Increases OPEC 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 Coppers Physical Deficit Likely Persist Coppers Physical Deficit Likely Persist Chart 4Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Chinas Refined Copper Supply Remains Tight Theoretically, 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 A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way Chart 6Copper Ore-Quality Declines Persist Through Capex Cycle A Perfect Energy Storm On The Way A Perfect Energy Storm On The Way 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 By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 8 Gold Prices Going Up Gold Prices Going Up 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 Higher Inflation On The Way Higher Inflation On The Way

Highlights We took a walk along a section of Fifth Avenue that is home to several mass affluent retailers, … : Sometimes strategists have to get out from behind their screens and take a look around, so we made a survey of the retail spaces on Fifth Avenue between 14th and 23rd Streets. … where the enormous glut of storefronts demonstrated that not every segment of the economy is subject to upward inflation pressure: We counted 78 spaces, only 49 of which were filled. It's a great time to rent retail space in the Flatiron/Union Square area and may well be in much of the rest of the country, too. Overall, the implications from our one-mile stroll appear to be constructive for financial markets and the economy: Stories about tight supplies and rising prices are getting all the headlines, but there are also pockets of the economy with excess capacity, and the inflation genie is not yet out of the bottle. Declining commercial rents help much more of the publicly traded universe than they hurt, and we still like equities. Feature Sometimes economists have to yank their heads out of the blizzard of data and models swirling around them and take a look at the real world beyond their screens. We did so last week, walking along a nine-block stretch of Manhattan’s lower Fifth Avenue. The segment, between 14th and 23rd Streets, runs from Greenwich Village’s prewar apartment buildings and nineteenth-century townhouses to the turn-of-the-century Flatiron Building, traversing the heart of Silicon Alley and running just west of some of the city’s best restaurants. Although the well-to-do long ago decamped uptown (Teddy Roosevelt’s and Edith Wharton’s childhood homes were within a block of our route), and the most elite retailers from the area’s Ladies’ Mile heyday followed, its heavy concentration of storefronts are generally filled by retailers seeking to appeal to a mass affluent constituency. In other words, it’s a nice area and one would expect those storefronts to be occupied, or in the process of being quickly refurbished to meet the needs of their next tenants, when the economy is booming. Instead, we find that only 49 of its 78 retail spaces are currently filled, leaving a whopping 37% vacancy rate.1 A two-part schematic of the properties shows the blocks from 14th to 19th Streets (Figure 1) and from 19th to 23rd Streets (Figure 2). The rendering treats every property as if it were the same size and makes no attempt to reflect its true relative scale. Blank spaces are inserted solely to balance blocks with unequal numbers of storefronts on the east and west side of the street. A vacancy’s most recent tenant is listed only when it can be definitively established by onsite and/or internet examinations. Figure 1Fifth Avenue Storefronts, 14th Street To 19th Street Nine Blocks Of Fifth Avenue Nine Blocks Of Fifth Avenue Figure 2Fifth Avenue Storefronts, 19th Street To 23rd Street Nine Blocks Of Fifth Avenue Nine Blocks Of Fifth Avenue A Tale Of (At Least) Two Economies The Many Winners The tumbleweeds blowing by the empty storefronts on Fifth Avenue illustrate the economic bifurcation that has resulted from the pandemic and the policy efforts undertaken to combat it. A handful of segments are suffering badly, which is par for the course after a recession, but an unusually high number of the rest are thriving. Many households in the bottom two-thirds of the income distribution have received more income than they would have if the pandemic had not occurred. The low-income unemployed were able to pocket more from augmented unemployment insurance (UI) benefits than they did from their jobs, while all singles earning $75,000 or less and married couples earning $150,000 or less were eligible for three rounds of economic impact payments that amounted to $3,200 per adult and $2,500 per child ($11,400 in total for a family of four). Constraints on their ability to spend their windfalls have bloated their savings and placed them on a sounder financial footing (Chart 1). Chart 1Aggregate Household Debt Is Manageable And Easy To Service Aggregate Household Debt Is Manageable And Easy To Service Aggregate Household Debt Is Manageable And Easy To Service Households in the upper reaches of the income distribution have seen their wealth expand as generous monetary and fiscal policy helped financial markets recover faster than you can say “exploding budget deficit.” Suburban and exurban homeowners have seen the value of their homes surge (Chart 2, top panel) and many homeowners, no matter where they reside, have been able to refinance their mortgages at lower rates (Chart 2, bottom panel), pushing down their monthly payments. Nearly all households that were able to maintain their income have saved more since the onset of COVID-19 simply because of their reduced ability to consume amidst activity restrictions (Chart 3). Chart 2Homeowners Have Had A Good Pandemic Homeowners Have Had A Good Pandemic Homeowners Have Had A Good Pandemic Chart 3Households' Pandemic Windfall Households' Pandemic Windfall Households' Pandemic Windfall Large-cap business borrowers, who have participated in the cascade of corporate bond issuance that has allowed them to pre-fund their cash needs, term out their debt and reduce their debt service burden, have also been among the winners. So, too, have small-business employees who continued to be paid thanks to the forgivable Paycheck Protection Program loans extended to their employers. They may not have reaped the rewards of the median unemployed worker who received UI benefits exceeding their pay by more than a third, but they did get to share in the economic impact payment bounty. Banks have escaped the credit losses that reliably accompany a recession (Chart 4) and can look forward to capital-boosting loan-loss reserve releases as the year proceeds. Chart 4Banks Have Had A Good Pandemic, Too Banks Have Had A Good Pandemic, Too Banks Have Had A Good Pandemic, Too The Losers Chart 5CRE Weakness Is Not A Systemic Threat CRE Weakness Is Not A Systemic Threat CRE Weakness Is Not A Systemic Threat The reason why the forgoing list of winners is so long, and indeed, why equities and credit have had such a good recession, is because Congress and the Fed stitched together an enormous safety net. It couldn’t break everyone’s fall, however, and so there have been some losers. At the top of the list are the proprietors of PPP businesses, like restaurants, bars, concert venues and independent theaters, which have operated at partial capacity (at best) or have simply seen demand evaporate as cities cleared out and office workers remained home. On the territory covered by our walking survey, Eisenberg’s,2 which had occupied the same space opposite the Flatiron Building from 1929 to 2020, is the poster child for this unfortunate group. These independent businesses’ landlords or the lenders who hold their mortgages must be feeling the pinch, too. Despite rock-bottom interest rates that have pushed down the cost of financing property purchases, retail property cap rates (akin to the inverse of their P/E ratios) have been creeping higher, reaching a seven-year high in March, per Real Capital Analytics data on Bloomberg. It is easy to envision portfolios of properties on the nine blocks of our survey generating losses, as even one space with no revenue can be enough to make a handful of properties a loser. It is also easy to see landlords missing mortgage payments. The good news for the financial system is that overall bank exposure to commercial real estate (CRE) loans is at the low end of its 35-year range (Chart 5, top panel), with small banks holding two-thirds of them (Chart 5, bottom panel). While CRE loans account for a quarter of small banks’ aggregate loan book, they comprise just 6% of large banks’ lending portfolios (Chart 5, middle panel). A CRE credit event would sting commercial mortgage-backed security (CMBS) investors, like the life insurers and pension funds that have been avid CMBS buyers, but it would not have any meaningful adverse impact on the availability of credit. Investment Takeaways From A Mile Of New York City Sidewalk Falling rents will help S&P 500 profit margins. Supply and demand dictate that retail rents on Fifth Avenue between 14th and 23rd Streets will fall. 37% of its spaces are empty and they are owned by a patchwork of individual landlords, represented by at least five separate CRE brokers. Competition among the landlords to rent the spaces – to get any revenue in the door to offset the fixed outflows for mortgage payments and property taxes – will be fierce, just as it will among the brokers seeking to capture commissions, and it should preclude any potential for supplier collusion. This is a lessees’ market if there ever was one. Table 1Tenants Outweigh Landlords In The S&P 500 Nine Blocks Of Fifth Avenue Nine Blocks Of Fifth Avenue The Fall 2020 edition of the semi-annual retail rent report compiled by the Real Estate Board of New York (REBNY) echoes that conclusion. The “decreases [in average asking price-per-square foot rents] are historic, with 11 corridors [of the 17 surveyed] experiencing their lowest … averages in at least a decade. While asking rents dropped significantly, taking rents can be much lower, with some brokers citing average differences … around 20%. Increases in retail availabilities and feedback from … brokers indicate that we are in a tenant’s market.”3 The vacancy picture is not so bleak everywhere across the country, but many shopping center, strip mall and enclosed mall owners are likely to have to drop prices or ease terms to entice tenants. A shift in surplus from landlords to retail tenants should be afoot nationally, just as it should be from office owners to office tenants. Those surplus shifts will benefit S&P 500 earnings, as the aggregate market capitalization of retailers with a physical store presence far outstrips the market cap of retail REITs, and the aggregate market cap of S&P 500 constituents that rent office space dwarfs the market cap of office REITs (Table 1). Brick-and-mortar retail isn’t dead. Chart 6Absence Makes The Heart Grow Fonder Absence Makes The Heart Grow Fonder Absence Makes The Heart Grow Fonder The rise of internet retailing has been perhaps the single biggest business development of the twenty-first century, and last spring’s lockdowns accelerated its already rapid market share gains. But e-commerce has lost some share in the early stages of relaxed restrictions and it will presumably lose more once a fully reopened economy allows people to re-engage in public activities (Chart 6). We do not challenge the proposition that e-commerce will take an even greater share of retail sales in the future, but the revealed preferences of retailers indicate that they believe it is important to maintain a physical presence. Retailers like The Gap, with three of its brands occupying the entire western side of Fifth from 17th to 18th Streets as well as the storefront at the southeast corner of Fifth and 18th (Figure 1), tout the strategic advantages of their omnichannel platforms, marrying a robust online presence with a well-located portfolio of physical stores. One could easily hawk Harry Potter-themed wares on the internet, but the impending opening of the massive Harry Potter store on the southeast corner of 22nd and 5th has generated buzz among the Peta children that would not have occurred virtually, given the cruel and horribly unfair restrictions that limit their online exposure. It and other brick-and-mortar retail concerns will find it easier to turn a profit in the current rental market.4 As both The Gap and lululemon noted in their earnings calls for the quarter ended January 31st, reduced rents contributed to wider gross margins. Runaway inflation is not a foregone conclusion, at least not any time soon. Central banking critics have been calling for runaway inflation ever since the Fed cut rates to zero and launched its large-scale asset purchases program in December 2008. They were further inflamed by QE2 in 2010 and QE3 in 2012, but their End-Is-Near warnings failed to come to pass. We expect that the combination of maximally easy monetary policy and fiscal largesse on an unprecedented scale may well produce annual consumer price increases that break out of the sleepy range that’s prevailed over the last two decades. As our previous two Strategy Reports have detailed, however, we don’t think the breakout is going to occur any time soon. The release of pent-up demand is sure to overwhelm restrained post-pandemic capacity in many segments of the economy. As a friend making travel arrangements from Washington, DC to Chicago for his daughter’s just-opened graduation ceremony reports, there were barely any available seats on flights and finding a hotel room in the Windy City was especially difficult. Inflation in those segments will be offset to some degree by commercial rent deflation, however, along with falling prices for used bar and restaurant equipment. Furthermore, we are confident that individuals and businesses throughout the economy will ramp up capacity as soon as it appears likely to be profitable. Employment will come back. All but the newest publicly traded retailers are actively engaged in rationalizing their physical store footprints, but Fifth Avenue’s vacant storefronts will not remain empty forever. Neither will all the spaces that held now-shuttered restaurants, bars and entertainment venues. There will be money to be made from the release of a year-plus of pent-up demand and sole proprietors, small businesses and national chains will jockey to capture their share of it. Any publicly traded company needs growth to satisfy the stock market and any concern that wishes to be acquired needs growth to obtain the highest possible sales price. Even if recovering retail activity initially takes the form of clusters of pop-up stores, conventional leases will again be signed once entrepreneurs get the sense that the demand to support business is here to stay. And once the businesses come, the employees to staff them will follow. April 2020 through May 2021 may have been a great fourteen months to be unemployed, but the United States is far from an idler’s paradise. When contractors’ and gig workers’ temporary UI benefit eligibility, along with the federal UI benefit supplement, expire everywhere by September and as early as June or July in 21 states and counting, people will return to work. Intervention creates winners and losers. If the authorities can’t bail out everyone when shocks hit the economy, there will be an observable divide between those who received support and those who didn’t. The gap between the winners and the losers may undermine social cohesion, but disparities offer professional investors an opportunity to separate themselves from the crowd. It might be a good time to acquire retail properties with sound longer-run prospects from holders whose financial positions may have become untenable. It may also be a good time to acquire businesses in the worst-hit segments, or to team up with the people who have the expertise to run them. Equities still have the wind at their back. When we came out from behind our terminal to do some first-hand research on Fifth Avenue, we also took note of the televised scenes from Madison Square Garden, less than a mile away to the north and west, and from Kiawah Island, off the coast of South Carolina. The spontaneous joy on display at the Garden and NBA playoff venues across the country as fans were once again able to come together to cheer on their favorite teams, and at the site of the PGA Championship, where the gallery engulfed popular soon-to-be champion Phil Mickelson and his playing partner as they made their way to the eighteenth green,5 leads us to believe that consumers are ready to be released from the past year’s constraints and gather, celebrate and spend. Looking around, we get the sense that a new, post-COVID chapter may have begun in the US. If the whole country is as keyed up as sports fans were two weekends ago, our view that corporate earnings growth can surpass even currently elevated expectations appears to be on track. As long as the virus truly is in retreat, equities will remain the place to be. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 We conducted our in-person survey of the properties on Sunday, May 23rd and Monday, May 24th from the sidewalk, without accessing any of the vacant spaces. Our 78-space count is based on the properties’ current configuration, which is subject to change upon alterations by the properties’ owners. 2History – Eisenbergs NYC 3 REBNY Research, "Manhattan Retail Report (Fall 2020)." Accessed May 27, 2021. 4 REBNY’s Fall 2020 Retail Rent Report found that mean asking rents on Fifth Avenue from 14th to 23rd had fallen by 22% year-over-year and noted that effective rents have reportedly been much lower than asking rents. 5Golf crowd pours onto Ocean Course, mobs Mickleson on 18 | The State