Monetary

Highlights Duration: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Corporate Bonds: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Disposable personal income fell in February compared to January, but it has risen massively since last year’s passage of the CARES act. The large pool of accumulated household savings will help drive economic growth as the pandemic recedes. Feature There is widespread anticipation that the economic recovery is about to kick into high gear. To us, this anticipation seems rather well founded. The United States’ vaccination roll-out is proceeding quickly and the federal government is pitching in with a tsunami of fiscal support. But it’s important to acknowledge that this positive outlook is still a forecast, one that has not yet been validated by hard economic data. The risk for investors is obvious. Market prices have already moved to price-in a significant amount of economic optimism and they are vulnerable in a situation where that optimism doesn’t pan out. In this week’s report we look at how much economic optimism is already discounted in both the Treasury and corporate bond markets. We conclude that the most likely scenario is one where the economic data are strong enough to validate current pricing in both markets. Investors should keep portfolio duration below-benchmark and continue to favor spread product over Treasuries, with a down-in-quality bias. Optimism In The Treasury Market The most obvious way to illustrate the economic optimism currently embedded in Treasury securities is to look at the rate hike expectations priced into the yield curve relative to the Fed’s own projections (Chart 1). The market is currently looking for four 25 basis point rate hikes by the end of 2023 while only seven out of 18 FOMC participants expect any hikes at all by then. Chart 1Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed We addressed the wide divergence between market and FOMC expectations in last week’s report.1 We noted that the main reason for the divergence is that while the market is focused on expectations for rapid economic growth the Fed is making a concerted effort to rely only on hard economic data. This sentiment was echoed by Fed Governor Lael Brainard in a speech last week:2 The focus on achieved outcomes rather than the anticipated outlook is central to the Committee’s guidance regarding both asset purchases and the policy rate. The emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than preemptive at this stage in the recovery. The upshot of the Fed’s excessively cautious approach is that its interest rate projections will move toward the market’s as the hard economic data strengthen during the next 6-12 months, keeping the bond bear market intact. As evidence for this view, consider that the US Economic Surprise Index remains at an extremely high level, consistent with a rising 10-year Treasury yield (Chart 2). Further, 12-month core inflation rates are poised to jump significantly during the next two months as the weak monthly prints from March and April 2020 fall out of the 12-month sample (Chart 3). Then, pipeline pressures in both the goods and service sectors will ensure that inflation remains relatively high for the balance of the year (Chart 3, bottom panel).3   Chart 2Data Surprises Remain Positive Data Surprises Remain Positive Data Surprises Remain Positive Chart 3Inflation About To Jump Inflation About To Jump Inflation About To Jump Finally, the hard economic data still do not reflect the truly massive amount of fiscal stimulus that is about to hit the US economy. Chart 4 illustrates how large last year’s fiscal stimulus was compared to what was seen during recent recessions, and this chart does not yet incorporate the recently passed $1.9 trillion American Rescue Plan (~8.7% of GDP) or the second infrastructure focused reconciliation bill that is likely to pass this fall. Our political strategists expect 2021’s second budget bill to be similar in size to the American Rescue Plan though tax hikes will also be included and, due to the infrastructure-focused nature of the bill, the spending will be more spread out over a number of years.4  Chart 4The Era Of Big Government Is Back That Uneasy Feeling That Uneasy Feeling Bottom Line: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration.  Optimism In The Corporate Bond Market Chart 5What's Priced In Junk Spreads? What's Priced In Junk Spreads? What's Priced In Junk Spreads? The way we assess the amount of economic optimism baked into the corporate bond market is to calculate the 12-month default rate that is implied by the current High-Yield Index spread (Chart 5). We need to make a few assumptions to do this. First, we assume that investors require an excess spread of at least 100 bps from the index after subtracting 12-month default losses. In past research, we’ve noted that High-Yield has a strong track record of outperforming duration-matched Treasuries when the realized excess spread is above 100 bps. High-Yield underperforms Treasuries more often than it outperforms when the realized excess spread is below 100 bps.5 Second, we must assume a recovery rate for defaulted bonds. The 12-month recovery rate tends to fluctuate between 20% and 60%, with higher levels seen when the default rate is low and lower levels when the default rate is high (Chart 5, bottom panel). For this week’s analysis, we assume a range of recovery rates, from 20% to 50%, though we expect the recovery rate to be closer to the top-end of that range during the next 12 months, given our expectations for a rapid economic recovery. With these assumptions in mind, we calculate that the High-Yield Index is fairly priced for a default rate between 2.8% and 4.5% for the next 12 months (Chart 5, panel 2). If the default rate falls into that range, or below, then we would expect High-Yield bonds (and corporate credit more generally) to outperform a duration-matched position in Treasuries. If the default rate comes in above 4.5%, then we would expect Treasuries to beat High-Yield. To figure out whether the default rate will meet the market’s expectations, we turn to a simple model of the 12-month speculative grade default rate that is based on nonfinancial corporate sector gross leverage (aka total debt over pre-tax profits) and C&I lending standards (Chart 6). If we make forecasts for nonfinancial corporate 12-month debt growth and pre-tax profit growth, we can let the model tell us what default rate to anticipate. Chart 6Default Rate Model Default Rate Model Default Rate Model Debt Growth Expectations We expect corporate debt growth to be quite weak during the next 12 months (Chart 7). This is mainly because firms raised a huge amount of debt last spring when the Fed and federal government made it very attractive to do so. Now, we are emerging from a recession and the nonfinancial corporate sector already holds an elevated cash balance (Chart 7, bottom panel). Debt growth was also essentially zero during the past six months, and very low (or even negative) debt growth is a common occurrence right after a peak in the default rate (Chart 7, top 2 panels). It is true that the nonfinancial corporate sector’s Financing Gap – the difference between capital expenditures and retained earnings – is no longer negative (Chart 7, panel 3). But it is also not high enough to suggest that firms need to significantly add debt. Chart 7Debt Growth Will Be Slow Debt Growth Will Be Slow Debt Growth Will Be Slow For our default rate calculations, we assume that corporate debt growth will be between 0% and 8% during the next 12 months. However, our sense is that it will be closer to 0% than to 8%. Profit Growth Expectations Chart 8Profit Growth Will Surge Profit Growth Will Surge Profit Growth Will Surge Our expectation is that profit growth will surge during the next 12 months, as is the typical pattern when the economy emerges from recession. Year-over-year profit growth peaked at 62% in 2002 following the 2001 recession, and it peaked at 51% in 2010 coming out of the Global Financial Crisis (Chart 8). More specifically, if we model nonfinancial corporate sector pre-tax profit growth on real GDP and then assume 6.5% real GDP growth in 2021, in line with the Fed’s median forecast, then we get a forecast for 31% profit growth in 2021. If we use a higher real GDP growth forecast of 10%, in line with our US Political Strategy service's "maximum impact" scenario, then our model forecasts pre-tax profit growth of 40% for 2021.6 Default Rate Expectations Table 1 puts together different estimates for profit growth and debt growth and maps them to a range of 12-month default rate outcomes, as implied by our Default Rate Model. For example, profit growth of 30% and debt growth between 0% and 8% in 2021 maps to a 12-month default rate of between 3.2% and 3.8%. This falls comfortably within the range of 2.8% to 4.5% that is consistent with current market pricing. Table 1Default Rate Scenarios That Uneasy Feeling That Uneasy Feeling In fact, for our model to output a default rate range that is higher than what is priced into junk spreads, we need to assume 2021 profit growth of 20% or less. This is quite far below the estimates we made above based on reasonable forecasts for real GDP. Bottom Line: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Household Income Update Last week’s personal income and spending report showed that disposable household income was lower in February than in January, a decline that is entirely attributable to the fact that the $600 checks to individuals that were part of the December stimulus bill were mostly delivered in January. These “Economic Impact Payments” totaled $138 billion in January and only $8 billion in February. This drop-off of $130 billion almost exactly matches the $128 billion monthly decline seen in disposable personal income. Consumer spending also fell in February compared to January, a result that likely owes a lot to February’s bad weather conditions, particularly the winter storm that caused much of Texas to lose power. Though spending has recovered a lot from last year’s lows, it remains significantly below its pre-COVID trend (Chart 9). In contrast to spending, disposable income has skyrocketed since the pandemic started last March. Chart 10 shows that disposable personal income has increased 8% in the 12 months since COVID struck compared to the 12 months prior. Moreover, it shows that the increase is entirely attributable to fiscal relief. Chart 9Households Have Excess ##br##Savings Households Have Excess Savings Households Have Excess Savings Chart 10Disposable Personal Income Growth And Its Drivers That Uneasy Feeling That Uneasy Feeling The result of below-trend spending and a surge in income is a big jump in the savings rate. The personal savings rate was 13.6% in February, well above its average pre-COVID level (Chart 9, panel 3), as it has been since the pandemic began. This consistently elevated savings rate has led to US households building up a $1.9 trillion buffer of excess savings compared to a pre-pandemic baseline (Chart 9, bottom panel). Perhaps the biggest question for economic growth is whether households will deploy this large pool of savings as the economy re-opens or whether they will continue to hoard it. In this regard, the individual checks that were part of last year’s CARES act are the most likely to be hoarded, as these checks were distributed to all Americans making less than $99,000. The income support provisions in this month’s American Rescue Plan are much more targeted. Only individuals making below $75,000 will receive a $1,400 check and the bill also includes expanded unemployment benefits and a large amount of aid for state & local governments. All in all, we anticipate that a substantial amount of household excess savings will be spent once the vaccination effort has made enough progress that people feel safe venturing out. This will lead to strong economic growth and higher inflation in the second half of 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20210323b.htm 3 For more details on our outlook for core inflation in 2021 please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 4 Please see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com 5 For more details on this excess spread analysis please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 The "maximum impact" scenario assumes that the full amount of authorized outlays from the American Rescue Plan will be spent, with 60% of the outlays spent in FY2021. For more details see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global manufacturing activity will soon peak due to growing costs and China’s policy tightening. This process will allow the dollar’s rebound to continue. EUR/USD’s correction will run further. This pullback in the euro is creating an attractive buying opportunity for investors with a 12- to 24-month investment horizon. Eurozone banks will continue to trade in unison with the euro. Feature The correction in the euro has further to run. The dollar currently benefits from widening real interest differentials, but a growing list of headwinds will cause a temporary setback for the global manufacturing sector, which will fuel the greenback rally further. Nonetheless, EUR/USD will stabilize between 1.15 and 1.12, after which it will begin a new major up-leg. Consequently, investors with a 12- to 24-month investment horizon should use the current softness to allocate more funds to the common currency. A Hiccup In Global Industrial Activity Global manufacturing activity is set to decelerate on a sequential basis and the Global Manufacturing PMI will soon peak. The first problem for the global manufacturing sector is the emergence of financial headwinds. The sharp rebound in growth in the second half of 2020 and the optimism created by last year’s vaccine breakthrough as well as the rising tide of US fiscal stimulus have pushed US bond yields and oil prices up sharply. These financial market moves are creating a “growth tax” that will bite soon. Mounting US interest rates have lifted global borrowing costs while the doubling in Brent prices has increased the costs of production and created a small squeeze on oil consumers. Thus, even if the dollar remains well below its March 2020 peak, our Growth Tax Indicator (which incorporates yields, oil prices and the US dollar) warns of an imminent top in the US ISM Manufacturing and the Global Manufacturing PMI (Chart 1). Already, the BCA Global Leading Economic Indicator diffusion index has dipped below the 50% line, which usually ushers in downshifts in global growth. A deceleration in China’s economy constitutes another problem for the global manufacturing cycle. Last year’s reflation-fueled rebound in Chinese economic activity was an important catalyst to the global trade and manufacturing recovery. However, according to BCA Research’s Emerging Market Strategy service, Beijing is now tightening policy, concerned by a build-up in debt and excesses in the real estate sector. Already, the PBoC’s liquidity withdrawals are resulting in a decline of commercial bank excess reserves, which foreshadows a slowing of China’s credit impulse (Chart 2). Chart 1The Global Growth Tax Will Bite The Global Growth Tax Will Bite The Global Growth Tax Will Bite Chart 2Chinese Credit Will Slow Chinese Credit Will Slow Chinese Credit Will Slow In addition to liquidity withdrawals, Chinese policymakers are also tightening the regulatory environment to tackle excessive debt buildups and real estate speculation. The crackdown on property developers and house purchases will cause construction activity to shrink in the second half of 2021. Meanwhile, tougher rules for both non-bank lenders and the asset management divisions of banks will further harm credit creation. BCA’s Chief EM strategist, Arthur Budaghyan, notes that consumer credit is already slowing. Chinese fiscal policy is unlikely to create a counterweight to the deteriorating credit impulse. China’s fiscal impulse will be slightly negative next year. Chinese financial markets are factoring in these headwinds, and on-shore small cap equities are trying to break down while Chinese equities are significantly underperforming global benchmarks. Chart 3Deteriorating Surprises Deteriorating Surprises Deteriorating Surprises Bottom Line: The combined assault from the rising “growth tax” and China’s policy tightening is leaving its mark. Economic surprises in the US, the Eurozone, EM and China have all decelerated markedly (Chart 3), which the currency market echoes. Some of the most pro-cyclical currencies in the G-10 are suffering, with the SEK falling relative to the EUR and the NZD and AUD both experiencing varying degrees of weakness. The Euro Correction Will Run Further… Until now, the euro’s decline mostly reflects the rise in US interest rate differentials; however, the coming hiccup in the global manufacturing cycle is causing a second down leg for the euro. First, the global economic environment remains consistent with more near-term dollar upside, due to: Chart 4Commodities Are Vulnerable Commodities Are Vulnerable Commodities Are Vulnerable A commodity correction that will feed the dollar’s rebound. Aggregate speculator positioning and our Composite Technical Indicator show that commodity prices are technically overextended (Chart 4). With this backdrop, the coming deceleration in Chinese economic activity is likely to catalyze a significant pullback in natural resources, which will hurt rates of returns outside the US and therefore, flatter the dollar. The dollar’s counter-cyclicality. The expected pullback in the Global Manufacturing PMI is consistent with a stronger greenback (Chart 5). The dollar’s momentum behavior. Among G-10 FX, the dollar responds most strongly to the momentum factor (Chart 6). Thus, the likelihood is high that the dollar’s recent rebound will persist, especially because our FX team’s Dollar Capitulation Index has only recovered to neutral from oversold levels and normally peaks in overbought territory.  Chart 5The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality The Greenback's Counter-Cyclicality Chart 6The Dollar Is A High Momentum Currency The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Second, the euro’s specific dynamics remain negative for now. Based on our short-term valuation model, the fair value of EUR/USD has downshifted back to 1.1, which leaves the euro 7% overvalued (Chart 7). Until now, real interest rate differentials and the steepening of the US yield curve relative to Germany’s have driven the decline in the fair value estimate. However, the deceleration in global growth also hurts the euro’s fair value because the US is less exposed than the Eurozone to the global manufacturing cycle. Chart 7The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 The Euro's Short-Term Fair Value Is At 1.1 Chart 8Speculators Have Not Capitulated Speculators Have Not Capitulated Speculators Have Not Capitulated The euro is also technically vulnerable, similar to commodities. Speculators are still massively net long EUR/USD and the large pool of long bets in the euro suggests that a capitulation has yet to take place (Chart 8). The euro responds very negatively to a weak Chinese economy. The Eurozone has deeper economic ties with China than the US. Exports to China account for 1.7% of the euro area’s GDP, and 2.8% of Germany’s compared to US exports to China at 0.5% of GDP. Indirect financial links are also larger. Credit to EM accounts for 45% of the Eurozone’s GDP compared to 5% for the US. Thus, the negative impact of a Chinese slowdown on EM growth has greater spillovers on European than on US ones rates of returns. A weak CNY and sagging Chinese capital markets harm the euro. The euro’s rebound from 1.064 on March 23 2020 to 1.178 did not reflect sudden inflows into European fixed-income markets. Instead, the money that previously sought higher interest rates in the US left that country for EM bonds and China’s on-shore fixed-income markets, the last major economies with attractive yields. These outflows from the US to China and EM pushed the dollar down, which arithmetically helped the euro. Thus, the recent EUR/USD correlates closely with Sino/US interest rate and with the yuan because the euro’s strength reflects the dollar demise (Chart 9). Consequently, a decelerating Chinese economy will also hurt EUR/USD via fixed-income market linkages. Finally, the euro will depreciate further if global cyclical stocks correct relative to defensive equities. Deep cyclicals (financials, consumer discretionary, energy, materials and industrials) represent 59% of the Eurozone MSCI benchmark versus 36% of the US index. Cyclical equities are exceptionally overbought and expensive relative to defensive names. They are also very levered to the global business cycle and Chinese imports. In this context, the expected deterioration in both China’s economic activity and the Global Manufacturing PMI could cause a temporary but meaningful pullback in the cyclicals-to-defensives ratio and precipitate equity outflows from Europe into the US (Chart 10). Chart 9EUR/USD And Chinese Rates EUR/USD And Chinese Rates EUR/USD And Chinese Rates Chart 10EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives EUR/USD Will Follow Cyclicals/Defensives Bottom Line: A peak in the global manufacturing PMI will hurt the euro, especially because China will meaningfully contribute to this deceleration in global industrial activity. Thus, the euro’s pullback has further to run. An important resistance stands at 1.15. A failure to hold will invite a rapid decline to EUR/USD 1.12. Nonetheless, the euro’s depreciation constitutes nothing more than a temporary pullback. … But The Long-Term Bull Market Is Intact We recommend buying EUR/USD on its current dip because the underpinnings of its cyclical bull market are intact. Chart 11Investors Structurally Underweight Europe Investors Structurally Underweight Europe Investors Structurally Underweight Europe First, investors are positioned for a long-term economic underperformance of the euro area relative to the US. The depressed level of portfolio inflows into Europe relative to the US indicates that investors already underweight European assets (Chart 11). This pre-existing positioning limits the negative impact on the euro of the current decrease in European growth expectations (Chart 11, bottom panel). Second, as we wrote last week, European growth is set to accelerate significantly this summer. Considering the absence of ebullient investor expectations toward the euro, this process can easily create upside economic surprises later this year, especially when compared to the US. Moreover, the deceleration in Chinese and global growth will most likely be temporary, which will limit the duration of their negative impact on Europe. Third, the US stimulus measure will create negative distortions for the US dollar. The addition of another long-term stimulus package of $2 trillion to $4 trillion to the $7 trillion already spent by Washington during the crisis implies that the US government deficit will not narrow as quickly as US private savings will decline. Therefore, the US current account deficit will widen from its current level of 3.5% of GDP. As a corollary, the US twin deficit will remain large. Meanwhile, the Fed is unlikely to increase real interest rates meaningfully in the coming two years because it believes any surge in inflation this year will be temporary. Furthermore, the FOMC aims to achieve inclusive growth (i.e. an overheated labor market). This policy combination forcefully points toward greater dollar weakness. The US policy mix looks particularly dollar bearish when compared to that of the Eurozone. To begin with, the balance of payment dynamics make the euro more resilient. The euro area benefits from the underpinning of a current account surplus of 1.9% of GDP. Moreover, the European basic balance of payments stands at 1.5% of GDP compared to a 3.6% deficit for the US. Additionally, FDI into Europe are rising relative to the US. The divergence in the FDI trends will continue due to the high probability that the Biden administration will soon increase corporate taxes. Chart 12The DEM In The 70s The DEM In The 70s The DEM In The 70s The combination of faster vaccine penetration and much larger fiscal stimulus means that the US economy will overheat faster than Europe’s. Because the Fed seems willing to tolerate higher inflation readings, US CPI will rise relative to the Eurozone. In the 1970s, too-easy policy in Washington meant that the gap between US and German inflation rose. Despite the widening of interest rate and growth differentials in favor of the USD or the rise in German relative unemployment, the higher US inflation dominated currency fluctuations and the deutschemark appreciated (Chart 12). A similar scenario is afoot in the coming years, especially in light of the euro bullish relative balance of payments. Fourth, valuations constitute an additional buttress behind the long-term performance of the euro. Our FX strategy team Purchasing Power Parity model adjusts for the different composition of price indices in the US and the euro area. Based on this metric, the euro is trading at a significant 13% discount from its long-term fair value, with the latter being on an upward trend (Chart 13).  Furthermore, BCA’s Behavioral Exchange Rate Model for the trade-weighted euro is also pointing up, which historically augurs well for the common currency. Lastly, even if the ECB’s broad trade-weighted index stands near an all-time high, European financial conditions remain very easy. This bifurcation suggests that the euro is not yet a major hurdle for the continent and can enjoy more upside (Chart 14). Chart 13EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value EUR/USD Trades Well Below Long-Term Fair Value Chart 14Easy European Financial Conditions Easy European Financial Conditions Easy European Financial Conditions Chart 15Make Room For the Euro! Make Room For the Euro! Make Room For the Euro! Finally, the euro will remain a beneficiary from reserve diversification away from the USD. The dollar’s status as the premier reserve currency is unchallenged. However, its share of global reserves has scope to decline while the euro’s proportion could move back to the levels enjoyed by legacy European currencies in the early 1990s (Chart 15). Large reserve holders will continue to move away from the dollar. BCA Research’s Geopolitical Strategy team argues that US tensions with China transcend the Trump presidency.  Meanwhile, the current administration’s relationship with Russia and Saudi Arabia will be cold. For now, their main alternative to the dollar is the euro because of its liquidity. Moreover, the NGEU stimulus program creates an embryonic mechanism to share fiscal risk within the euro area. The Eurozone is therefore finally trying to evolve away from a monetary union bereft of a fiscal union. This process points toward a lower probability of a break up, which makes the euro more attractive to reserve managers. Bottom Line: Despite potent near-term headwinds, the euro’s long-term outlook remains bright. Global investors already underweight European assets, yet balance of payment and policy dynamics point toward a higher euro. Moreover, valuations and geopolitical developments reinforce the cyclical tailwinds behind EUR/USD. Thus, investors with a 12- to 24-month investment horizon should use the current euro correction to gain exposure to the European currencies. Any move in EUR/USD below 1.15 will generate a strong buy signal. Sector Focus: European Banks And The Istanbul Shake The recent decline in euro area bank stocks coincides with the 14% increase in USD/TRY and the 17% decline in the TUR Turkish equities ETF following the sacking of Naci Ağbal, the CBRT governor. President Erdogan is prioritizing growth over economic stability because his AKP party is polling poorly ahead of the 2023 election. The Turkish economy is already overheating, and the lack of independence of the CBRT under the leadership of Şahap Kavcıoğlu promises a substantial increase in Turkish inflation, which already stands at 16%. Hence, foreign investors will flee this market, creating further downward pressures on the lira and Turkish assets. European banks have a meaningful exposure to Turkey. Turkish assets account for 3% of Spanish bank assets or 28% of Tier-1 capital. For France, this exposure amounts to 0.7% and 5% respectively, and for the UK, it reaches 0.3% and 2%. As a comparison, claims on Turkey only represent 0.3% and 0.5% of the assets and Tier-1 capital of US banks. Unsurprisingly, fluctuations in the Turkish lira have had a significant impact one the share prices of European banks in recent years, even after controlling for EPS and domestic yield fluctuations (Table 1). Table 1TRY Is Important To European Banks… The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Nonetheless, today’s TRY fluctuations are unlikely to have the same lasting impact on European banks share prices as they did from 2017 to 2019 because European banks have already shed significant amounts of Turkish assets (Chart 16).  This does not mean that European banks are out of the woods yet. The level of European yields remains a key determinant of the profitability of Eurozone’s banks, and thus, of their share prices (Chart 17, top panel). Moreover, the euro still tightly correlates with European bank stocks as well (Chart 17, bottom panel). As a result, our view that the global manufacturing cycle will experience a temporary downshift and the consequent downside in EUR/USD both warn of further underperformance of European banks. Chart 16… But Less Than It Once Was The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Chart 17Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things Higher Yields And A stronger Euro, These Are Few Of My Favorite Things These same views also suggest that this decline in bank prices is creating a buying opportunity. Ultimately, we remain cyclically bullish on the euro and the transitory nature of the manufacturing slowdown implies that global yields will resume their ascent. The cheap valuations of European banks, which trade at 0.6-times book value, make them option-like vehicles to bet on these trends, even if the banking sectors long-term prospects are murky. Moreover, they are a play on Europe’s domestic recovery this summer. We will explore banks in greater detail in future reports.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Fixed Income Performance Government Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Corporate Bonds The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Equity Performance Major Stock Indices The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Geographic Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward Sector Performance The Euro Dance: One Step Back, Two Steps Forward The Euro Dance: One Step Back, Two Steps Forward  

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of 2021 and beyond. Next week, please join me for a webcast on Thursday, April 1 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Growth outlook: The global economy will rebound over the course of the year, with momentum rotating from the US to the rest of the world. Inflation: Structurally higher inflation is not a near-term risk, even in the US, but could become a major problem by the middle of the decade. Global asset allocation: Investors should continue to overweight equities on a 12-month horizon. Unlike in the year 2000, the equity earnings yield is still well above the bond yield. Equities: Value stocks will maintain their recent outperformance. Investors should favor banks and economically-sensitive cyclical sectors, while overweighting stock markets outside the US. Fixed income: Continue to maintain below average interest-rate duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: While the dollar could strengthen in the near term, it will weaken over a 12-month period. Large budget deficits, a deteriorating balance of payments profile, and an accommodative Fed are all dollar bearish. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Strong Chinese growth will continue to buoy the metals complex. I. Macroeconomic Outlook Global Growth: The US Leads The Way… For Now The global economy should rebound from the pandemic over the remainder of the year. So far, however, it has been a two-speed recovery. Whereas the Bloomberg consensus has US real GDP growing by 4.8% in the first quarter, analysts expect the economies in the Euro area, UK, and Japan to contract by 3.6%, 13.3%, and 5%, respectively. Chart 1Dismantling Of Lockdown Measures Occurring At Varying Pace Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 2US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders US Is Among The Vaccination Leaders Two things explain US growth outperformance. First, the successful launch of the US vaccination campaign has allowed state governments to begin dismantling lockdown measures (Chart 1). Currently, the US has administered 40 vaccine shots for every 100 inhabitants. Among the major economies, only the UK has performed better on the vaccination front (Chart 2). In contrast, parts of continental Europe are still battling a new wave of Covid infections, prompting policymakers there to further tighten social distancing rules. Second, US fiscal policy has been more stimulative than elsewhere (Chart 3). On March 11, President Biden signed the $1.9 trillion American Rescue Plan Act into law. Among other things, the Act provides direct payments to lower- and middle-class households, extends and expands unemployment benefits, and offers aid to state and local governments (Chart 4). Unlike President Trump’s Tax Cuts and Jobs Act, the Democrats’ legislation will raise the incomes of the poor much more than the rich (Chart 5). Chart 3The US Tops The Stimulus Race Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We expect growth leadership to shift from the US to the rest of the world in the second half of the year. Nevertheless, US real GDP in Q4 of 2021 will probably end up 7% above the level of Q4 of 2020, enough to close the output gap. In Section II of this report, we discuss whether this could cause inflation to take off on a sustained basis. We conclude that such an outcome is unlikely for the next two years. However, materially higher inflation is indeed a risk over a longer-term horizon. Chart 4Composition Of The American Rescue Plan Act Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 5Biden’s Package Will Boost The Income Of The Poor More Than The Rich Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   The EU: Recovery After Lockdown The EU will benefit from a cyclical recovery later this year as the vaccination campaign picks up steam. The recent weakness in Europe was concentrated in services (Chart 6). The latest European PMI data shows that the service sector may have turned the corner. As in the US, European households have accumulated significant excess savings. The unleashing of pent-up demand should drive consumption over the remainder of the year (Chart 7). Chart 6For Now, The Service Sector Is Doing Better In The US Than The Euro Area Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 7European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings European Households Have Accumulated Excess Savings Meanwhile, the manufacturing sector continues to do well, with the Euro area manufacturing PMI hitting all-time highs in March. Sentiment indices such as the Sentix and ZEW surveys point to further upside for manufacturing activity (Chart 8).   Chart 8Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Positive Outlook For Euro Area Manufacturing Activity Fiscal policy should also turn modestly more expansionary. The EU recovery fund will begin disbursing aid in the second quarter. This should allow the southern European economies to maintain more generous levels of fiscal support. It also looks increasingly likely that the Green Party will either lead or join the coalition government in Germany, which could translate into greater spending. UK: Recovering From A One-Two Punch The UK had to shutter its economy late last year due to the emergence of a new, more contagious, strain of the virus. The resulting hit to the economy came on top of a decline in exports to the EU following Brexit. The economic picture will improve over the coming months. Thanks to the speedy vaccination campaign, the government plans to lift the “stay at home” rules on March 29. Most retail, dining, and hospitality businesses are scheduled to reopen on April 12. A strong housing market and the extension of both the furlough schemes and tax holidays should also sustain demand. Japan: More Fiscal Support Needed Like many other countries, Japan had to introduce new lockdown measures in late 2020 after suffering its worst wave of the pandemic. While the number of new cases has dropped dramatically since then, they have edged up again over the past two weeks. Japanese regulations require that vaccines be tested on Japanese people. Prime Minster Yoshihide Suga has promised that vaccine shots will be available to the country’s 36 million seniors by the end of June. However, with less than 1% of the population vaccinated so far, strict social distancing will persist well into the summer. The Japanese government passed a JPY 73 trillion (13.5% of GDP) supplementary budget in December. However, only 40 trillion of that has been allocated for direct spending. Due to negative bond yields, the Japanese government earns more interest than it pays on its debt. It should be running much more expansionary fiscal policy. China: Policy Normalization, Not Deleveraging Chart 9China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China: Tailwind For Easier Monetary And Fiscal Policies Will Fade Over The Remainder Of The Year China’s combined credit/fiscal impulse peaked late last year (Chart 9). The impulse leads growth by about six months, implying that the tailwind from easier monetary and fiscal policies will fade over the rest of the year. Nevertheless, we doubt that China’s economy will experience much of a slowdown. First and foremost, the shock from the pandemic should fade, helping to revive consumer and business confidence. Second, the Chinese authorities are likely to pursue policy normalization, rather than outright deleveraging. Jing Sima, BCA’s chief China strategist, expects the general government deficit to remain broadly stable at 8% of GDP this year. She also thinks that the rate of credit expansion will fall by only 2-to-3 percentage points in 2021, bringing credit growth back in line with projected nominal GDP growth of 8%. Total credit was 290% of GDP at end-2020. Thus, credit growth of 8% would still generate 290%*8%=23% of GDP of net credit formation, providing more than enough support to the economy. II. Feature: Will The US Economy Overheat? As of February, US households were sitting on around $1.7 trillion in excess savings. About two-thirds of those savings can be chalked up to reduced spending during the pandemic, with the remaining one-third arising from increased transfer payments (Chart 10). The recently passed stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. This cash hoard will support spending. Already, real-time measures of economic activity have hooked up. Traffic congestion in many US cities is approaching pre-pandemic levels. OpenTable’s measure of restaurant occupancy is progressing back to where it was before the pandemic (Chart 11). J.P. Morgan reported that spending using its credit cards rose 23% year-over-year in the 9-day period through to March 19 as stimulus payments reached bank accounts. Anecdotally, airlines and cruise line companies have been expressing optimism on the back of a surge in bookings. Chart 10Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Chart 11Real-Time Measures Of Economic Activity Have Hooked Up Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   Meanwhile, the supply side of the economy could face temporary constraints. Under the stimulus bill, close to half of jobless workers will receive more income through to September from extended unemployment benefits than they did from working. This could curtail labor supply at a time when firms are trying to step up the pace of hiring. The Fed Versus The Markets In the latest Summary of Economic Projections released last week, the median “dot” for the fed funds rate remained stuck at zero through to end-2023. The bond market, in contrast, expects the Fed to start raising rates next year. Why is there a gap between the Fed and market expectations? Part of the answer is that the “dots” and market expectations measure different things. Whereas the dots reflect a modal, or “most likely” estimate of where short-term rates will be over the next few years, market expectations reflect a probability-weighted average. The fact that rates cannot fall deeply into negative territory – but can potentially rise a lot in a high-inflation scenario – has skewed market rate expectations to the upside. That said, there is another, more fundamental, reason at work: The Fed simply does not think that a negative output gap will lead to materially higher inflation. The “dots” assume that core PCE inflation will barely rise above 2% over the next two years, even though, by the Fed’s own admission, the unemployment rate will fall firmly below NAIRU in 2023 (Chart 12). Chart 12The Fed Sees Faster Recovery, Same Rate Path Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 13Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Just Like It Did In 2011, The Fed Will Disregard What It Sees As Transitory Price Shocks Is the Federal Reserve’s relaxed view towards inflation risk justified? The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s deflationary shock, lingering supply chain disruptions, the rebound in gasoline prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory (Chart 13). The Fed believes that PCE inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as supply disruptions dissipate and most fiscal stimulus measures roll off. Our bet is that the Fed will be right about inflation in the near term, but wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation is poised to rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and market participants. War-Time Inflation, But Which War? In some respects, the Fed sees the current environment as resembling a war, except this time the battle is against an invisible enemy: Covid-19. Chart 14 shows what happened to US inflation during WWI, WWII, the Korean War, and the Vietnam War. In the first three of those four wars, inflation rose but then fell back down after the war had concluded. That is what the Fed is counting on. What about the possibility that the coming years could resemble the period around the Vietnam War, where inflation continued to rise even though the number of US military personnel engaged in the conflict peaked in 1968?   Chart 14Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Inflation During Wartime: Which War Is Most Relevant For Today? Chart 15Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s In the near term, this does not appear to be a major risk. In 1966, when the war effort was ramping up, the US unemployment rate was two percentage points below NAIRU (Chart 15). As of February, US employment was still more than 5% below pre-pandemic levels.   Chart 16Employment Has Been Weak And Edging Lower At The Bottom Quartile Of The Wage Distribution Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? We estimate that the US output gap currently stands at around 5%-to-6% of GDP. Among the bottom quartile of the wage distribution, employment is 20% below pre-pandemic levels, and has been edging lower, not higher, since last October (Chart 16). Thus, for now, hyperbolic talk of how fiscal stimulus is crowding out private-sector spending is unwarranted. Inflation Nation Looking further out, the parallels between today and the late sixties are more striking. As we discussed in a report titled 1970s-Style Inflation: Yes, It Could Happen Again, much of what investors believe about how inflation emerged during the late 1960s is either based on myths, or at best, half-truths. To the extent that there are differences between today and that era, they don’t necessarily point to lower inflation in the coming years. For example, in the late sixties, the baby boomers were entering the labour force, supplying the economy with a steady stream of new workers. This helped to temper wage pressures. Today, baby boomers are leaving the labour force. They accumulated a lot of wealth over the past 50 years – so much so that they now control more than half of all US wealth (Chart 17). Over the coming two decades, they will run down that wealth, implying that household savings rates could drop. By definition, a lower savings rate implies more spending in relation to output, which is inflationary. Chart 17Baby Boomers Have Accumulated A Lot Of Wealth Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? III. Financial Markets A. Portfolio Strategy Overweight Stocks Versus Bonds Stocks usually outperform bonds when economic growth is strong and money is cheap (Chart 18). The end of the pandemic and ongoing fiscal stimulus should support growth over the next 12-to-18 months, allowing the bull market in equities to continue. With inflation slow to rise, monetary policy will remain accommodative over this period. Chart 18AStocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Stocks Usually Outperform Bonds When Economic Growth Is Strong... Chart 18B... And Money Is Cheap ... And Money Is Cheap ... And Money Is Cheap The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, our research has shown that as long as bond yields do not rise enough to trigger a recession, stocks will shrug off the effect of higher yields (Chart 19 and Table 1). Indeed, there is a self-limiting aspect to how high bond yields can rise, and stocks can fall, in a setting where inflation remains subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today. Chart 19What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise? What Happens To Equities When Treasury Yields Rise?   Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?   It’s Not 2000 In recent months, many analysts have drawn comparisons between the year 2000 and the present day. While there are plenty of similarities, ranging from euphoric retail participation to the proliferation of dubious SPACs and IPOs, there is one critical difference: The forward earnings yield today is above the real bond yield, whereas in 2000 the earnings yield was below the bond yield (Chart 20). The US yield curve inverted in February 2000, with the 10-year Treasury yield peaking a month earlier at 6.79%. An inverted yield curve is one of the most reliable recession predictors. We are a far cry from such a predicament today. By the same token, the S&P 500 dividend yield was well below the bond yield in 2000. Today, they are roughly the same. Even if one were to pessimistically assume that US companies are unable to raise nominal dividend payments at all for the next decade, the S&P 500 would need to fall by 20% in real terms for equities to underperform bonds. Many other stock markets would have to decline by an even greater magnitude (Chart 21). Chart 20Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Relative To Bonds, Stocks Are More Favorably Valued Now Than In 2000 Chart 21Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds   Protecting Against Long-Term Inflation Risk The bull market in stocks will end when central banks begin to fret over rising inflation. In the past, central banks have used forecasts of inflation to decide when to raise rates. The Federal Reserve’s revised monetary policy framework, which focuses on actual rather than forecasted inflation, almost guarantees that inflation will overshoot the Fed’s target. This is because monetary policy fully affects the economy with a lag of 12-to-18 months. By the time the Fed decides to clamp down on inflation, it will have already gotten too high. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios, favor inflation-protected securities over nominal bonds, and own more “real assets” such as property. In fact, one of the best inflation hedges is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades, you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms. Gold Versus Cryptos Historically, gold has offered protection against inflation. Increasingly, many investors have come to believe that cryptocurrencies are a better choice. We disagree. As we recently discussed in a report titled Bitcoin: A Solution In Search Of A Problem, not only are cryptocurrencies such as Bitcoin highly inefficient mediums of exchange, they are also likely to turn out to be poor stores of value. Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 22). About 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. Much of the rest of the mining takes place in countries such as Russia and Belarus with dubious governance records. Bitcoin and ESG are heading for a clash. We suspect ESG will win out. Chart 22Bitcoin Is Not Your Eco-Currency Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? B. Equities Favor Cyclicals, Value, And Non-US Stocks Chart 23Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing Cyclicals And Ex-US Stocks Do Best When Global Growth Is On The Upswing The vast majority of stock market capitalization today is concentrated in large multinational companies that are more leveraged to global growth rather than to the growth rate of countries in which they happen to be domiciled. Thus, while country-specific factors are not irrelevant, regional equity allocation often boils down to figuring out which stock markets will gain or lose from various global trends. The end of the pandemic will prop up global growth. In general, cyclical sectors outperform when global growth is on the upswing (Chart 23). As Table 2 illustrates, stock markets outside the US have more exposure to classically cyclical sectors such as industrials, energy, materials, and consumer discretionary that usually shine coming out of a downturn. This leads us to favor Europe, Japan, and emerging markets. We place banks in the cyclical category because faster economic growth tends to reduce bad loans, while also placing upward pressure on bond yields. Chart 24 shows that there is a very close correlation between the relative performance of bank shares and long-term bond yields. As government yields trend higher, banks will benefit. Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 24Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Close Correlation Between Relative Performance Of Banks And Long-Term Bond Yields Banks and most other cyclical sectors dominate value indices (Table 3). Not only is value still exceptionally cheap in relation to growth, but traditional value sectors have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 25). The likelihood that global bond yields put in a secular bottom last year, coupled with the emergence of a new bull market in commodities, makes us think that the nascent outperformance of value stocks has years to run.   Table 3Breaking Down Growth And Value By Sector Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 25AValue Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Value Is Attractive On Multiple Levels (I) Chart 25BValue Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) Value Is Attractive On Multiple Levels (II) US Corporate Tax Hikes Coming Finally, there is one country-specific factor worth mentioning, which reinforces our view of favoring non-US, cyclical, and value stocks: US corporate taxes are heading higher. BCA’s geopolitical strategists expect the Biden Administration and the Democrat-controlled Congress to raise the statutory corporate tax rate from 21% to as high as 28% later this year in order to fund, among other things, a major infrastructure investment program. Capital gains taxes will also rise. While tax hikes are unlikely to bring down the whole US stock market, they will detract from the relative performance of US stocks compared with their international peers. Cyclical sectors will benefit from the infrastructure spending. To the extent that such spending boosts growth and leads to a steeper yield curve, it should also benefit banks. In contrast, tech companies outside the clean energy sector will lag, especially if the bill introduces a minimum corporate tax on book income and raises taxes on overseas profits, as President Biden pledged to do during his campaign. C. Fixed Income Expect More US Curve Steepening As discussed above, inflation in the US and elsewhere will be slow to take off. However, when inflation does rise later this decade, it could do so significantly. Investors currently expect the Fed to start raising rates in December 2022, bringing the funds rate to 1.5% by the end of 2024 (Chart 26). In contrast, we think that a liftoff in the second half of 2023, preceded by a 6-to-12 month period of asset purchase tapering, is more likely. This implies a modest downside for short-dated US bond yields. Chart 26The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 The Market Sees The Fed Rate Hike Cycle Kicking Off In Late 2022 Chart 27Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels Long-Term US Real Yield Expectations Have Recovered But Remain Below Pre-Pandemic Levels In contrast, long-term yields will face upward pressure first from strong growth, and later from higher inflation. The 5-year/5-year forward TIPS yield currently stands at 0.35%, which is still below pre-pandemic levels (Chart 27). Given structurally looser fiscal policy, the 5-year/5-year forward TIPS yield should be at least 50 basis points higher, which would translate into a 10-year Treasury yield of a bit over 2%. Regional Bond Allocation While the Fed will be slow out of the gate to raise rates, most other central banks will be even slower. The sole exception among developed market central banks is the Norges bank, which has indicated its intention to hike rates in the second half of this year. Conceivably, Canada could start tightening monetary policy fairly soon, given strong jobs growth and a bubbly housing market. While the Bank of Canada is eager to begin tapering asset purchases later this year, our global fixed-income strategists suspect that the BoC will wait for the Fed to raise rates first. An early start to rate hikes by the Bank of Canada could significantly push up the value of the loonie, which is something the BoC wants to avoid. New Zealand will also hike rates shortly after the Fed, followed by Australia. Bank of England governor Andrew Bailey has downplayed the recent rise in gilt yields. Nevertheless, the desire to maintain currency competitiveness in the post-Brexit era will prevent the BoE from hiking rates until 2024. Among the major central banks, the ECB and the BoJ will be the last major central banks to raise rates. Putting it all together, our fixed-income strategists advocate maintaining a below-benchmark stance on overall duration. Comparing the likely path for rate hikes with market pricing region by region, they recommend overweighting the Euro area and Japan, assigning a neutral allocation to the UK, Canada, Australia, and New Zealand, and an underweight on the US. Credit: Stick With US High Yield Corporates Corporate spreads have narrowed substantially since last March. Nevertheless, in an environment of strong economic growth, it still makes sense to favor riskier corporate credit over safe government bonds. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over Euro area bonds. The former trade with a higher yield and spread than the latter (Chart 28). CHART 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (I) Chart 28Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) Favor High-Yield Bonds Over Investment-Grade And US Corporates Over Euro Area (II) One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit-sensitive asset starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the middle of the distribution. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the Euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 29). Chart 29US High-Yield Stands Out The Most Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? D. Currencies Faster US Growth Should Support The Dollar In The Near Term… Chart 30US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies US Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The US has a “low beta” economy. Compared to most other economies, the US has a bigger service sector and a smaller manufacturing base (Chart 30). The US economy is also highly diversified on both a regional and sectoral level. This tends to make US growth less volatile than growth abroad. The relatively low cyclicality of the US economy has important implications for the US dollar. While the US benefits from stronger global growth, the rest of the world usually benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, dragging down the value of the dollar. This relationship broke down this year. Rather than lagging other economies, the US economy has led the charge thanks to bountiful fiscal stimulus and a successful vaccination campaign. As growth estimates for the US have been marked up, the dollar has caught a temporary bid (Chart 31). Chart 31US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar US Growth Outperformance Could Be A Near-Term Tailwind For The Dollar … But Underlying Fundamentals Are Dollar Bearish As discussed earlier in the report, growth momentum should swing back towards the rest of the world later this year. This should weigh on the dollar in the second half of the year. To make matters worse for the greenback, the US trade deficit has ballooned in recent quarters. The current account deficit, a broad measure of net foreign income flows, rose by nearly 35% to $647 billion in 2020. At 3.1% of GDP, it was the largest shortfall in 12 years (Chart 32). Consistent with the weak balance of payments picture, the dollar remains overvalued by about 10% on a purchasing power parity basis (Chart 33). Chart 32The Widening US External Gap The Widening US External Gap The Widening US External Gap Chart 33The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value The Dollar Is Expensive Based On Its PPP Fair Value Historically, the dollar has weakened whenever fiscal policy has been eased in excess of what is needed to close the output gap (Chart 34). Foreigners have been net sellers of Treasurys this year. It is equity inflows that have supported the dollar (Chart 35). However, if non-US stock markets begin to outperform, foreign flows into US stocks could reverse. Chart 34The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs The Greenback Tends To Weaken When Fiscal Policy Is Eased Relative To What The Economy Needs Chart 35Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Equity Inflows Supported The Dollar This Year (I) Chart 35Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Equity Inflows Supported The Dollar This Year (II) Meanwhile, stronger US growth has pushed long-term real interest rate differentials only modestly in favor of the US. At the short end of the curve, real rate differentials have actually widened against the US since the start of the year, reflecting rising US inflation expectations and the Fed’s determination to keep rates near zero for an extended period of time (Chart 36). Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (I) Chart 36Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) Real Rate Differentials Have Moved In Favor Of The Dollar At The Long End Of The Curve, But Not At The Short End (II) On balance, while the dollar could strengthen a bit more over the next month or so, the greenback will weaken over a 12-month horizon. Chester Ntonifor, BCA’s chief currency strategist, expects the dollar to fall the most against the Norwegian krone, Swedish krona, Australian dollar, and British pound over a 12-month horizon. In the EM space, stronger global growth will disproportionately benefit the Mexican peso, Chilean peso, Colombian peso, South African rand, Czech koruna, Indonesian rupiah, Korean won, and Singapore dollar. Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (I) Chart 37Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Weak Dollar Is Usually A Tailwind For Cyclicals, Non-US Stocks, And Value Stocks (II) Consistent with our equity views, a weaker dollar would be good news for cyclical equity sectors, non-US stock markets, and value stocks (Chart 37). E. Commodities Favorable Outlook For Commodities Strong global growth against a backdrop of tight supply should sustain momentum in the commodity complex over the next 12-to-18 months. Capital investment in the oil and gas sector has fallen by more than 50% since 2014 (Chart 38). BCA’s Commodity & Energy Strategy service, led by Robert Ryan, expects annual growth in crude oil demand to outstrip supply over the remainder of this year (Chart 39). Chart 38Oil & Gas Capex Collapses In COVID-19’s Wake Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Chart 39Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year Crude Oil Demand Growth To Outstrip Supply Over The Remainder Of This Year A physical deficit in the metals markets – particularly for copper and aluminum – should also persist this year (Chart 40). While the boom in electric vehicle (EV) production represents a long-term threat to oil, it is manna from heaven for many metals. A battery-powered EV can contain more than 180 pounds of copper compared with 50 pounds for conventional autos. By 2030, the demand from EVs alone should amount to close to 4mm tonnes of copper per year, representing about 15% of annual copper production. Chart 40ACopper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Copper Will Be In Physical Deficit... Chart 40B...As Will Aluminum ...As Will Aluminum ...As Will Aluminum China’s Commodity Demand Will Remain Strong Chart 41China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities China Keeps Buying More And More Commodities Strong demand for metals from China should also buoy metals prices. While trend GDP growth in China has slowed, the economy is much bigger in absolute terms than it was in the 2000s. China’s annual aggregate consumption of metals is five times as high as it was back then. The incremental increase in China’s metal consumption, as measured by the volume of commodities consumed, is also double what it was 20 years ago (Chart 41). As we discussed in our report To Deleverage Its Economy, China Needs MORE Debt, the Chinese government has no choice but to continue to recycle persistently elevated household savings into commodity-intensive capital investment. This will ensure ample commodity demand from China for years to come. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Global Investment Strategy View Matrix Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Special Trade Recommendations Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh? Current MacroQuant Model Scores Second Quarter 2021 Strategy Outlook: Inflation Cometh? Second Quarter 2021 Strategy Outlook: Inflation Cometh?

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage Global Semiconductor Shortage Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 8Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls German Conservatives Waver in Polls German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 11Germany Puts Multilateralism To The Test Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 12UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Fiscal stimulus is no longer a free lunch. US mortgage applications are down by 20 percent since the start of February. With rising bond yields now starting to choke private sector borrowing, bond yields are nearing an upper-limit, and even a reversal point. In which case, the tide out of defensives into cyclicals, and growth into value, will be a tide that reverses. New 6-month recommendation: underweight US banks (XLF) versus consumer staples (XLP). Fractal trade shortlist: US banks, bitcoin, ether, and GBP/JPY. Feature Chart of the WeekMortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Why would anybody not get excited about trillions of dollars of fiscal stimulus? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield, it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending has crowded out a dollar of private sector spending. In this case, fiscal stimulus will have no impact on GDP. The fiscal multiplier will be zero. Under some circumstances though, fiscal stimulus does not crowd out the private sector and the fiscal multiplier is extremely high. 2020 was the perfect case in point. As the pandemic gripped the world, much of the private sector was on its knees. Or to be more precise, in lockdown at home, doing nothing, receiving no income, and unwilling and unable to borrow. In such a crisis, the government became the ‘borrower of last resort’. It could, and had to, borrow at will to replace the private sector’s lost income and thereby to stabilise the collapse in demand. With no competition from private sector borrowers for the glut of excess savings, bond yields stayed depressed. Meaning that fiscal stimulus was a free lunch: it had lots of benefit with little cost (Chart I-2). Chart I-2Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Is No Longer A Free Lunch Covid-19 is still with us, and could be with us forever. Yet the economy will adapt and even thrive with structural changes, such as decentralisation, hybrid office/home working, a shift to online shopping, and less international travel. In fact, all these structural changes were underway long before Covid-19. Meaning that the pandemic was the accelerant rather than the cause of what was happening to the economy anyway. As the private sector now gets back on its feet to restructure, spend, and invest accordingly, fiscal stimulus is no longer a free lunch. Fiscal stimulus is most effective when it is not pushing up the bond yield. To repeat, last year’s massive fiscal stimulus was highly effective because it had little impact on the bond yield, so there was no crowding out of private sector borrowing. The markets have fully priced the 2021 stimulus, but not the crowding out. However, the most recent stimulus package has pushed up the bond yield or, at least, is a major culprit for the recent spike in yields. Hence, there will be some crowding out of private sector borrowing. Worryingly, US mortgage applications, for both purchasing and refinancing, are down by 20 percent since the start of February (Chart of the Week and Chart I-3). Chart I-3Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent The resulting choke on private sector borrowing and investment will at least partly negate any putative boost from this fiscal stimulus. The concern is that the markets have fully priced the stimulus, but not the crowding out. Time To Rotate Back In our February 18 report, The Rational Bubble Is Turning Irrational, we warned that high-flying tech stocks were at a point of vulnerability. Specifically, since 2009, the technology sector earnings yield had always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of a ‘rational bubble.’ In February, this envelope was breached, indicating that tech stock valuations were in a new and irrational phase (Chart I-4). Chart I-4The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The warning proved to be prescient. In the second half of February, tech stocks did sell off sharply and entered a technical correction.1 As a result, tech-dominated stock markets such as China and the Netherlands also suffered sharp declines. Proving once again that regional and country stock market performance is nothing more than an extension of sector performance (Chart I-5). Chart I-5As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets But the aggregate stock market has remained more resilient than we expected, and is only modestly down versus its mid-February peak. The reason is that while highly-valued growth stocks suffered the anticipated correction, value stocks continued to advance (Chart I-6). Chart I-6Time To Rotate Back Time To Rotate Back Time To Rotate Back We can explain this divergence in terms of the three components of stock market valuation: The bond yield. The additional return or ‘risk premium’ for owning stocks. The expected growth of earnings. Tech and other growth stocks are ‘long-duration’ assets meaning that their earnings are weighted into the distant future. Hence, for growth stocks the relevant valuation comparison is a long-duration bond yield, say the 10-year yield. Whereas for ‘shorter-duration’ value stocks the relevant valuation comparison is a shorter-duration bond yield, say the 2-year yield. Given that the 10-year yield has risen much more than the 2-year yield, the pain has been much more pronounced for growth stock valuations. Turning to the ‘risk premium’ for owning stocks, at ultra-low bond yields the risk premium just moves in tandem with the bond yield. Hence, as the 10-year yield has spiked, the combination of a rising yield plus a rising risk premium has doubled the pain for growth stock valuations. For a detailed explanation of this dynamic please see our February 18 report. Regarding the expected growth of earnings, the market believes that stimulus is much more beneficial for economically sensitive value stocks than for economically insensitive growth stocks. But now that we are at the point where rising bond yields are starting to choke private demand, the rise in bond yields is nearing a limit, and even a reversal point. In which case, the strong tide out of defensives into cyclicals will also be a tide that reverses. On this basis, and supported by the strong technical arguments in the next section, we are opening a new 6-month position: Underweight US banks versus US consumer staples, expressed as underweight XLF versus XLP. US Banks, Bitcoin, Ether, And The Pound This week we have identified susceptibilities to countertrend moves in three areas. The bullish groupthink in US banks is at an extreme. First, based on its fragile fractal structure, the (bullish) groupthink in US banks versus consumer staples is at an extreme approaching February 2016 (bearish), December 2016 (bullish), and March 2020 (bearish). All these previous extremes in fragility proved to be turning points in relative performance. If this proves true again, the next six months could see a reversal of US bank outperformance (Chart I-7). Chart I-7The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme Second, we are extremely bullish on the structural prospects for cryptocurrencies, and are preparing a report detailing the compelling investment case. Look out for it. That said, the composite fractal structures of both bitcoin and ethereum indicate that they are technically very overbought (Chart I-8 and Chart I-9). Accordingly, we are hoping for pullbacks that provide better strategic entry points for bitcoin at $40,000, and for ethereum at $1300. Chart I-8Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Chart I-9Ethereum Is Technically Overbought Ethereum Is Technically Overbought Ethereum Is Technically Overbought Third, the UK’s Covid-19 vaccination program was one of the fastest out of the blocks. As the vaccination rate quickly rose to over half the adult population (based on at least one vaccination dose), the pound was a major beneficiary. But now, the UK vaccination program is facing the hurdle of reduced supplies. Additionally, there is the danger that the third wave of infections in Continental Europe washes onto the shores of Britain. Hence, the recent strong rally in the pound is susceptible to a countertrend reversal (Chart 10). This week’s recommended trade is short GBP/JPY setting the profit target and symmetrical stop-loss at 2.2 percent. Chart I-10The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 A technical correction is defined as a 10 percent price decline. Fractal Trading System Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Asset Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Equity Market Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​​​

Highlights Duration & The Fed: Unlike the bond market, the Fed is being intentionally cautious about how quickly it revises its interest rate expectations higher, focusing more on hard economic data than on surveys. We expect the Fed dots to move up later this year as the hard economic data improve, validating current pricing in the bond market. Maintain below-benchmark portfolio duration. Yield Curve: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up. Feature The pain in the bond market continues. The 10-year Treasury yield rose again last week, closing at 1.74% on Friday, and the Bloomberg Barclays Treasury Index has now returned -6.1% since it peaked last August. If we use the peak-to-trough drawdown in the Treasury Index as our gauge, we are now in the midst of one of the five worst bond selloffs of the past 50 years. During that 50-year period, the current bearish bond move is only surpassed by the 2009, 2003, 1994 and 1980 episodes (Chart 1). Chart 1A Historic Bond Rout A Historic Bond Rout A Historic Bond Rout That said, the current bond selloff might still have a lot of runway. In level terms, the 30-year Treasury yield has only just recaptured its 2020 peak and the 10-year yield hasn’t even done that (Chart 2). Then, there’s another 101 bps of upside in the 30-year yield and 150 bps of upside in the 10-year yield just to get back to their 2018 peaks, yield levels that aren’t exactly distant memories. Yields do look stretched if we look at long-dated forwards. The 5-year/5-year forward Treasury yield, for example, is already well above its 2020 peak. The large increase in the 5-year/5-year forward yield is the result of Fed policy keeping the short-end of the yield curve capped (Chart 2, bottom 2 panels) forcing the bulk of Treasury weakness to be felt at the long-end. The 5-year/5-year forward Treasury yield is important because it reflects the market’s expectation of where the fed funds rate will settle in the long-run. In fact, you can use survey estimates of the long-run neutral fed funds rate to get a useful fair value range for the 5-year/5-year forward. At present, the 5-year/5-year forward yield has pushed well above this survey-derived fair value range (Chart 3), though it’s important to note that it is still 75 bps below its 2018 peak. Survey estimates of the long-run neutral fed funds rate were revised down as growth disappointed in 2019, it stands to reason that they could be revised higher as growth improves this year, thus moving the fair value range up as well. Chart 2Yields Can Rise Further Yields Can Rise Further Yields Can Rise Further Chart 35-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated In fact, whether that process of upward revisions to survey estimates of the long-run neutral fed funds rate begins is an important near-term question for the bond market. Upward revisions would signal further upside in long-dated yields and more curve steepening ahead. Static long-run neutral rate estimates would signal that the upside in long-maturity yields is limited. In that latter case, the cyclical bond bear market would transition to a less severe bear-flattening phase where short-maturity yields eventually catch up to the long-end as the Fed tightens policy. It’s currently unclear how those survey estimates will evolve – we will get March updates for both surveys shown in Chart 3 on April 8th – but for now it’s too soon to say that the 5-year/5-year forward yield has peaked. We continue to recommend maintaining below-benchmark portfolio duration as we keep tabs on our Checklist To Increase Portfolio Duration.1 Currently, our Checklist is not screaming out for us to make a change. Explaining The Disagreement Between The Fed And The Market We expected that Fed policymakers would revise up their interest rate forecasts at last week’s FOMC meeting, but we also expected that the forecasts wouldn’t rise far enough to match the rate hike path that is currently priced in the market.2 This is in fact what happened, though the Fed was slightly more dovish than we anticipated. Only 7 out of 18 FOMC participants expect any rate hikes at all before the end of 2023, while the overnight index swap curve is discounting more than four 25 basis point hikes by then (Chart 4). Chart 4Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed What explains this divergence between the market and the Fed? Perhaps bond investors are simply ignoring the Fed’s dovish message. In that case, we should expect yields to fall as it becomes clear that the Fed intends to keep rates pinned at zero for much longer than is currently priced in the curve. Or perhaps Fed policymakers just don’t appreciate the surge in economic activity that is about to unfold. In that case, their interest rate forecasts (the “dots”) will rise sharply in the coming months as the economic data improve. Chair Powell gave a hint about how we should think about the divergence between the market and the “dots” in his post-meeting press conference. He said that the Fed wants to see “actual progress” towards its economic objectives not “forecast[ed] progress”, and he noted that this increased focus on “actual progress” is “a difference from our past approach.”3 In other words, the Fed is making a concerted effort to take a more backward-looking approach to policymaking under its new Average Inflation Targeting regime. It doesn’t want to tighten policy in response to a forecast of stronger growth in the future only to get whipsawed if that forecast doesn’t pan out. It would rather err on the side of tightening too late and then possibly have to move more quickly if it falls behind the curve. The market, by contrast, is a purely forward-looking discounting mechanism. Market prices move quickly to incorporate new information but are often caught offside. We are reminded of Paul Samuelson’s famous quip that the stock market has predicted nine of the past five recessions. This explains exactly what is happening right now. The market is looking ahead, taking its cues from survey data (or “soft data”) such as the ISM indexes that are pointing toward a sharp rise in economic activity and inflation. The Fed, by contrast, is endeavoring to focus more on the actual hard economic data such as the unemployment rate, industrial production and consumer price indexes. These hard economic data simply haven’t improved that much yet. The last section of this report (titled “Economy: Hard Vs Soft Data”) gives some examples of how the hard and soft economic data have diverged. Chart 5The Path Back To Maximum Employment The Path Back To Maximum Employment The Path Back To Maximum Employment Ultimately, the disagreement between the market’s funds rate expectations and the Fed’s dots will be resolved as the hard economic data are released during the next few months. Those data will either validate the current message from economic surveys, causing the Fed to revise up its rate forecasts, or disappoint market expectations, causing market forecasts and bond yields to fall. In this regard, the hard economic data on the labor market will be particularly important. The Fed has said that it will not lift rates until “maximum employment” is achieved. In practice, “maximum employment” means that the unemployment rate will fall into a range of 3.5% - 4.5%, consistent with the Fed’s estimates of the natural rate, and the labor force participation rate will recover to pre-COVID levels (Chart 5). The top row of Table 1 shows that average monthly employment growth of 419k is required to achieve that target by the end of 2022. We have made the case in prior reports that, though that number seems high, it is achievable.4   Table 1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date The Fed Looks Backward While Markets Look Forward The Fed Looks Backward While Markets Look Forward It’s also worth noting that the Fed’s median unemployment rate forecast was revised significantly lower last week. The Fed is now looking for an unemployment rate of 4.5% by the end of this year and 3.9% by the end of 2022 (Chart 5, top panel). The fact that the Fed doesn’t project any rate hikes during this timeframe can only mean that policymakers aren’t forecasting a similar recovery in the labor force participation rate. The bottom line is that, unlike the market, the Fed is being intentionally cautious about how quickly it revises its funds rate expectations higher, focusing more on hard economic data than surveys. Eventually, the disagreement between the hard and soft economic data will be resolved and either the Fed dots will move toward the market, or the market will move toward the Fed. Our sense is that the Fed is probably being overly cautious and that their forecasts will eventually move toward the market, validating current bond yields. Too Early To Expect Curve Flattening We have been recommending nominal Treasury curve steepeners for some time, on the view that the yield curve will trade directionally with yields. This means that rising yields will coincide with curve steepening.5 This correlation has held up extremely well, but we know that it won’t last forever. Eventually, we will be close enough to Fed rate hikes that the yield curve will start to flatten as yields rise. This process will begin at the long-end of the curve and gradually shift toward the short-end as Fed liftoff approaches. Chart 6 shows how the correlation between the level of Treasury yields and different yield curve slopes has held up during the recent surge in bond yields. For the most part, the tight correlation between rising yields and steeper curves remains intact, with the 10/30 slope being the exception (Chart 6, bottom panel). It looks like during the past month the 10/30 slope has transitioned from a bear-steepening/bull-flattening regime into a bear-flattening/bull-steepening regime. The investment implication is that the short position of a curve steepener trade should be applied to the 10-year note not the 30-year bond, particularly for duration-neutral steepeners. It’s difficult to know exactly when the other segments of the yield curve will transition from their bear-steepening/bull-flattening regimes into bear-flattening/bull-steepening regimes, but we suspect that the current correlations have quite a bit more running room. If we look at what occurred prior to the last time that the Fed lifted rates off the zero bound, in December 2015, we see that most curve segments didn’t start to bear-flatten until a few months before liftoff (Chart 7) Chart 6Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Chart 7Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff In terms of how to implement a yield curve steepener, we have been recommending a position long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. We are sticking with that position for now, as it has performed well even as the 2/5/10 butterfly spread has widened in recent weeks (Chart 8). We expect it will continue to perform well as long as both the 2/5 and 5/10 yield curve slopes continue to steepen. Once we suspect that the 5/10 slope is transitioning into a bear-flattening/bull-steepening regime, we will have to either shift into a curve flattener or a curve steepener that is focused more at the short-end of the curve. Chart 85/10 Slope Still Steepening 5/10 Slope Still Steepening 5/10 Slope Still Steepening Bottom Line: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: Hard Vs. Soft Data Chart 9IP Lags The PMI IP Lags The PMI IP Lags The PMI Chart 10Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead As noted above, the US economy is at an interesting inflection point where, owing to large-scale fiscal stimulus and an effective COVID vaccination rollout, there is a lot of optimism about the future. This optimism is showing up in how people respond to surveys about their economic and business expectations, but it has not yet translated into better actual economic outcomes. The ISM Manufacturing PMI survey is a case in point. It surged to 60.8 in February, its highest level since 2018, but actual measured industrial production continues to contract in year-over-year terms (Chart 9). In all likelihood, this is simply a result of surveys (“soft data”) leading the hard data. A simple linear regression fit between industrial production and the PMI shows that wide negative divergences have a habit of showing up during recessions, only for the gaps to close very quickly in the early stages of the recovery. We see the same dynamic at play in the inflation data. Actual core CPI inflation has not moved up significantly, but surveys indicate that price pressures are rising fast (Chart 10). Bottom Line: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on our Checklist please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210317.pdf 4 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, Dhaval Joshi has started publishing the new BCA Research Counterpoint product, in which he will continue to apply his unique process to dig up original investment opportunities around the globe. I trust many of you will continue to read Dhaval’s excellent and thought-provoking work. I also hope to keep your readership as I take the helm of the European Investment Strategy product, where I will apply BCA’s time-tested method which emphasizes analysis of global liquidity and economic trends to forecast European market outcomes. Thank you for your continued trust and support. Best regards, Mathieu Savary   Highlights The Eurozone’s economy lags the US’s because of weakness in the service sector. Poor vaccine rollouts and tighter fiscal policy explain this bifurcated outcome. Even though Europe will continue to trail the US this year, the summer period will see a sharp European recovery. Investors can take advantage of this rebound by buying the cyclical equities that have lagged during last year’s rally. Favor the French, Italian and Spanish equity markets over the German and Dutch markets. The Bank of England does not need to fight rising Gilt yields; favor the pound over the euro as the UK-German spread widens. The Norges Bank will be the first G-10 central bank to lift rates, which will hurt EUR/NOK. Fade any hawkish noise coming from the German election season. Feature The service sector constitutes the biggest drag on the Eurozone’s economy, which will cause European growth to trail that of the US further. The euro area’s fundamental problem is that it lags the US significantly on both vaccination and fiscal stimulus fronts. Nonetheless, by the summer, the European service sector will start catching up, which will favor a basket of sectors exposed to the economic re-opening that have lagged until now. The Service Sector Remains Under The Weather The consensus is correct to expect European growth to lag that of the US in 2021, even if the extent of the shortfall does not hit the 4% currently penciled in by Bloomberg. Chart 1The Service Sector Is the Problem The Service Sector Is the Problem The Service Sector Is the Problem Unlike normal business cycles, the service sector is now Europe’s biggest handicap, while the manufacturing sector is performing in line with that of the US (Chart 1, top panel). On both sides of the Atlantic, industrial activity has benefited from the same set of positives in recent quarters. Goods purchases were the only outlet for pent-up demand built up in the first and second quarter of 2020. Extraordinarily accommodative global liquidity conditions and record-low interest rates boosted spending on big-ticket items, especially in light of the housing boom that has engulfed the globe. Finally, China’s rapid recovery fueled a swift rebound in the demand for natural resources, autos and machinery that benefited manufacturers the world over. Service activity did not enjoy a similar unified tailwind. Consequently, while the US Services PMI stands at a seven-year high, the Eurozone’s lingers at 45.7, in contraction territory (Chart 1, middle panel). The weaker confidence of European households sheds light on this bifurcated performance (Chart 1, bottom panel). Health and fiscal policies are the main headwinds in the Eurozone that have hurt its service sector and hampered the mood of its households, at least compared to the US. With regard to health policy, the poor vaccination rates on the European continent create the greatest problem. The vaccination effort has only reached 11.8, 11.1, 11.9 and 12.5 doses per 100 person in Germany, France, Italy and Spain respectively. In the US and the UK, authorities have already delivered more than 30 doses per 100 person (Chart 2). As a result, while infection and death per capita are rapidly declining in the US and in the UK, mortality is once again rising in France as well as in Italy and caseloads are increasing there and in Germany. Moreover, hospitalization rates and ICU usage in France, Germany, Italy or Portugal are once again trending up, and in some cases they are hitting threatening levels for the healthcare system. In response to these COVID-19 dynamics, governments in many major Eurozone countries are resorting to the re-imposition of restrictions. Italy has announced new lockdowns in half of its 20 regions while France just entered its third lockdown over the weekend. By contrast, the stringency of restrictions is set to ease in the UK and the US. In the US, limitations were already imposed or followed more laxly relative to the euro area (depending on the state) and mobility was improving (Chart 3). Chart 2Slow Vaccination In The Eurozone Slow Vaccination In The Eurozone Slow Vaccination In The Eurozone Chart 3The Stringency Of Lockdowns Matter The Stringency Of Lockdowns Matter The Stringency Of Lockdowns Matter Despite the lower mobility created by stricter restrictions in the Eurozone, the US government has opened the fiscal tap much more aggressively than European governments (Chart 4). Since the beginning of the crisis, the US fiscal help has reached 25% of GDP, while in Italy, Germany, France or Spain the budget deficits have swelled by a more modest 14%, 10%, 9% and 13% of GDP, respectively. True, European governments have also offered credit guarantees totaling EUR3 trillion euros, but these sums only have a very indirect impact on aggregate demand and should mostly be understood as liquidity insurance to prevent a liquidity crisis from morphing into a solvency crisis. Chart 4Tight Fists On The Continent Summer Of ‘21 Summer Of ‘21 For the remainder of 2021, European fiscal policy is unlikely to be eased compared to the US. BCA Research’s Geopolitical strategy team anticipates the Biden government to add a further $2 trillion dollars of spending by the end of 2021, mostly in the form of long-term and infrastructure outlays, in addition to the $1.9 trillion recently legislated.While the European Union’s NGEU plan is an important step in the integration of European fiscal policy, its generous EUR750 billion envelope will be disbursed over five years. This implies a debt-based fiscal expansion of 1% per annum between 2021 and 2024 (the years of maximum disbursements). Individual state plans are also limited. Bottom Line: The European economy is lagging the US economy because of the inferior performance of its service sector. This disadvantage is the consequence of both a slower vaccine rollout that is negatively impacting mobility and a much more timid fiscal policy. Relief Is On Its Way The Eurozone’s service sector and domestic economic performance is nonetheless set to improve, despite the current health and fiscal policy deficiencies. First, the economy continues to adapt to its new socially distanced form. In the second quarter of 2020, the imposition of lockdowns caused the euro area’s quarterly GDP to collapse by 11%. The contribution to GDP of the retail, wholesale, artistic, entertainment, and hospitality sectors tumbled to -7.3%. In Q4 2020, as European governments were imposing equally stringent lockdowns, quarterly GDP growth fell to -0.1% and the contribution to growth of the same sectors only hit -0.54%. Second, the continental vaccination campaign is progressing. It is easy to worry that it will take a very long time to vaccinate the entire population, but the main reason to impose lockdowns is to preserve capacity in the healthcare system. Thus, the priority is to inoculate 50-year olds and above because they constitute 90% of hospitalizations. Through this aperture, even if the pace of vaccination remains tepid in Europe, the goal to decrease economic restrictions can reasonably be achieved by summer. Moreover, with Pfizer’s logistical issues corrected, the pace of vaccination can accelerate. Concerns remain over the population’s willingness to receive the vaccines, but these issues will fade as well. The current worries surrounding the AstraZeneca vaccines provide an example. The incidence of thromboembolic events is marginally higher than for the general population and the European Medicines Agency deemed the AstraZeneca vaccines safe, especially in light of the human costs of the disease it prevents. As caseloads and mortality rates decline in Israel, the UK and the US, even French elderlies will become more willing to receive their vaccines. Table 1Parsimonious But Constant Fiscal Stimulus… Summer Of ‘21 Summer Of ‘21 Third, fiscal policy will remain easy. True, European government support is tepid compared to the US, but the continual drip of new policy measures shows that authorities are not intransigent (Table 1). In all likelihood, the various furlough and employment protection schemes implemented since the spring of 2020 are likely to remain in place this year even if lockdowns decrease. Their impact on employment was major and they contributed meaningfully to preserve household income (Chart 5). Finally, COVID-19 is a seasonal illness and summer is on its way in Europe. The experience of 2020, when vaccines and testing were much more limited than they are today, has taught us that in the summer months, this coronavirus spreads much less. Therefore, seasonal patterns will allow a relaxation of social distancing measures. Chart 5Furloughs Played A Crucial Role Summer Of ‘21 Summer Of ‘21 In this context, service activity in the Eurozone will improve, which will boost GDP. European households, like their US counterparts, have accumulated significant excess savings (Chart 6). Furthermore, global manufacturing activity will remain robust, which will support employment and household income in the Eurozone. Hence, consumer confidence will improve and some of the EUR300 billion in excess savings will make its way into the economy. The service sector should be the prime beneficiary of this money because households have already fulfilled a large proportion of their pent-up demand for goods. What they now want to do is to go out, go to restaurants and spend their income on experiences. The rebound in the contribution to GDP of the retail and recreation sectors will be accretive to job and household income, unleashing a virtuous circle of activity (Chart 7). Chart 6European Are Building Their Nest Egg too European Are Building Their Nest Egg too European Are Building Their Nest Egg too Chart 7Services Will Contribute Again to Growth Services Will Contribute Again to Growth Services Will Contribute Again to Growth Bottom Line: In 2021, the euro area’s economy will further lag that of the US, but investors should nonetheless expect a robust uptick in service activity this summer. How To Play The Summer Recovery? Chart 8Buy The Laggards / Sell the Leaders Summer Of ‘21 Summer Of ‘21 Five weeks ago, BCA Research’s US Equity Sector Strategy service designed a strategy to buy the laggards within a basket of sectors that should benefit from the recovery while selling the “back-to-work” stocks that had already priced in that recovery.  This recommendation protects investors against potential hiccups in the re-opening trade and is simple to implement: sell/underweight the pro-cyclical sectors that stand above their February 19 relative peak and buy/overweight those that remain below their relative highs (Chart 8). In the Eurozone context, this strategy involves focusing on the cyclical sectors, and buying/overweighting these cyclical stocks that stand below their pre-COVID high relative to the MSCI benchmark while selling/underweighting those that have punched above this threshold. Chart 9 illustrates the sectors to favor and the ones to avoid using this methodology. In essence, not only should the “laggards” baskets experience a catch up in earnings, but also, the shift in sentiment should prompt a re-rating of relative valuations (Chart 10). Chart 9Who Are the Laggards And the Leaders? Summer Of ‘21 Summer Of ‘21 This strategy makes sense beyond the COVID-19 dynamics. From a global perspective, the basket of sectors purchased (the laggards”) outperforms the former “leaders” after global bond yields increase (Chart 11, top panel). This relationship reflects the heavy representation of financials in the “laggards” basket while tech and the interest rates-sensitive automobile sector are key constituents of the “leaders” basket. Additionally, the former “leaders” are more exposed to the Chinese business cycle than the “laggards". Chart 10Relative Valuations will Adjust Relative Valuations will Adjust Relative Valuations will Adjust Chart 11Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders The deceleration in the Chinese economy is a problem for the “leaders” relative performance (Chart 11, bottom panel). China’s credit impulse has rolled over as Beijing aims to prevent excess speculation in the real estate sector. Moreover, a regulatory tightening is taking place in the Middle Kingdom, which will further slow its economy. Already, the new orders-to-inventories ratio from the NBS PMI reflects the downside risk for the Chinese economy, which highlights the threat to the previous high-flying leaders. A strategy that favors the former “laggards” at the expense of the previous “leaders” also has implications for geographical allocation within euro area equities. As Table 2 shows, Italy, France and Spain over represent the “laggards” in their national benchmarks while the Netherlands and Germany overweight the “leaders”. On a net basis, the tech-heavy Netherlands is the country to avoid, with a 27% relative underweight for the “laggards”, while Spain and Italy should be favored, with their 24% and 22% overweight in the “laggards” relative to the “leaders”. Spain and Italy in particular will also benefit from a further narrowing in sovereign spreads that will boost the performance of their financial sector while the re-opening of trade continues. Additionally, investors should favor France at the expense of Germany. Table 2France, Italy, and Spain Over The Netherlands And Germany Summer Of ‘21 Summer Of ‘21 Bottom Line: The economic re-opening favors the Eurozone cyclicals that still trade below their February 19 2020 relative highs as the expense of those cyclicals that have already overtaken their pre-COVID peaks. This means buying/overweighting the Banks, Insurance, Energy and Aerospace & Defense sectors at the expense of the IT, Automobiles and Building products sectors. It also implies a preference for Italian and Spanish equities, especially relative to Dutch equities. Country Focus: The BoE Follows the Fed, Not The ECB Last Thursday, the Bank of England followed in the Fed’s footprints, not the ECB’s. The BoE refrained from adding to its asset purchases, even if this year, 10-year Gilt yields are rising in line with the Treasuries and rapidly outpacing Bund yields. However, the BoE remains committed to keeping short rates at record lows and it keeps the window open for rate cuts if economic conditions ever warrant it. We agree with the Bank of England that the UK’s economic outlook has improved in recent months. The extension of both the furlough schemes and tax holidays, along with the rapid pace of vaccination in the British Islands point to robust growth in the coming quarters. Nonetheless, the picture is not without blemish. Specifically, the UK’s exports to the EU are collapsing in wake of Brexit. Moreover, the pace of vaccination in the UK is set to slow a bit over the coming months. These risks to the outlook are unlikely to topple the economy, because the vigor of the UK’s housing market is an important support to domestic demand. While the UK’s labor market remains frail, the strength of the RICS housing survey suggests that real wages will stay well bid (Chart 12). The increase in household income will cause consumption to accelerate sharply once lockdowns are eased. This could accentuate inflationary pressures this year, and cause inflation over the next few years to trend higher relative to the euro area. Chart 12UK Real Wages Have Upside UK Real Wages Have Upside UK Real Wages Have Upside With this economic backdrop, the market’s pricing of the SONIA curve is appropriate. Over the past month, the OIS curve has steepened significantly (Chart 13). The BoE is comfortable with that pricing and considers the back up in interest rates to be reflective of stronger growth and not constraining of activity. In fact, financial conditions are roughly unchanged since the MPC’s last meeting, which highlights that rising risk asset prices have compensated for an appreciating pound and rising gilt yields. Chart 13SONIA Is Climbing Up, And The BoE Is Fine With It SONIA Is Climbing Up, And The BoE Is Fine With It SONIA Is Climbing Up, And The BoE Is Fine With It Bottom Line: The SONIA curve will continue to shift higher relative to the EONIA curve. Consequently, the spread between Gilt and Bund yields will widen further and EUR/GBP will depreciate more over the coming six to nine months, especially because the pound keeps trading at a discount. Moreover, thanks to their domestic focus and lower sensitivity to the pound, UK mid-cap and small-cap stocks will outperform the FTSE-100. Country Focus: Norges Bank, First Out Of The Gate Chart 14The Norges Bank Will Raise Rates First The Norges Bank Will Raise Rates First The Norges Bank Will Raise Rates First Last Thursday, Governor Øystein Olsen indicated that the Norges Bank would increase interest rates from zero later this year, which validates the message of the Norwegian swap curve. Looking at economic fundamentals, investors should not bet against this outcome. BCA’s Central Bank Monitor confirms that the Norges Bank will be the first central bank in the West to lift interest rates (Chart 14). It is the only one of our Monitors in “Tight Money Required” territory. The message from our Norges Bank Monitor reflects the prompt recovery of the Norwegian economy. Thanks to rebounding Brent prices and rapidly expanding production at the new Johan Sverdrup oil field (the largest in the North Sea), Norwegian nominal exports are growing at a double-digit pace. Meanwhile Norwegian retail sales are increasing at a 16% annual rate. Beyond some near-term COVID worries, consumer spending will remain robust because the strong employment component of the PMI points to solid job gains and a rapidly rising consumer confidence. Finally, Norwegian inflation is already above the central bank’s target of 2%, with core CPI at 2.05% and headline inflation at 3.3%. Chart 15A Weaker EUR/NOK ahead A Weaker EUR/NOK ahead A Weaker EUR/NOK ahead Thanks to Norway’s economic performance, the krone remains one of the favorite currencies of BCA’s Foreign Exchange Strategy service.  The global economic environment creates additional tailwind for the NOK. A continued global economic recovery will allow oil prices to rise further on a 12- to 18-month basis, which should lead to a weaker EUR/NOK (Chart 15). In a similar vein, the NOK is particularly sensitive to the USD dollar’s fluctuations. As a result, BCA’s negative cyclical stance toward the USD will create an important support for the NOK, even if the greenback’s countertrend bounce could last another quarter or so. Finally, along with the SEK, the NOK is the cheapest pro-cyclical currency in the G10, trading at a 5% discount to its fair value. Thus, the Norwegian krone should benefit greatly from continued risk taking this year. Bottom Line: The Norwegian krone remains one of the most attractive currencies in the world. The status of the Norges Bank as the front-runner to lift rates this year only amplifies the NOK’s appeal. A Few Words On Germany’s State Elections Chart 16German Party Polling German Party Polling German Party Polling The defeat of Angela Merkel’s CDU party in the states of Baden-Wurttemberg and Rhineland-Palatinate highlights that the German electorate is moving slowly to the left. According to BCA’s Geopolitical Strategy Service, it is too early to tell whether a left-wing coalition will take power in Germany this fall. However, the marginal shift toward the SPD and the Green Party indicates that even the CDU will have to listen to the median voter’s demands (Chart 16).  Practically, this means that German politics will push for more European integration and that ultimately, more fiscal stimulus will materialize in Europe over the coming years. As a result, investors should fade any hit to the euro or European assets caused by hawkish sounds made by CDU potential leaders during the campaign for the September federal election.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Cyclical Recommendations Structural Recommendations Trades Closed Trades Currency Performance Summer Of ‘21 Summer Of ‘21 Fixed Income Performance Government Bonds Summer Of ‘21 Summer Of ‘21 Corporate Bonds Summer Of ‘21 Summer Of ‘21 Equity Performance Major Stock Indices Summer Of ‘21 Summer Of ‘21 Geographic Performance Summer Of ‘21 Summer Of ‘21 Sector Performance Summer Of ‘21 Summer Of ‘21  

Highlights The latest “dot plot” from the Fed reaffirmed the FOMC’s intention to keep rates near zero for at least the next two years, despite evidence that the US economy will recover from the pandemic much faster than expected. The Fed’s reluctance to telegraph any rate hikes stems in part from its conviction that the neutral rate of interest has declined. A lower neutral rate implies that monetary policy may not be as accommodative as widely believed. Whereas Fed officials have argued that the neutral rate has fallen due to structural factors outside their control, critics insist that the Fed’s own actions have painted it into a corner.  By cutting rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble. Moreover, low rates have encouraged governments and the private sector to take on more debt. All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. While we disagree with the view that easier monetary policy has made things worse, we do agree that elevated asset prices and high debt levels limit the Fed’s room for maneuver. In this week’s report, we contend that the low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation starting by the middle of this decade. Growth Dots Up, Rate Dots Not The FOMC released its latest Summary of Economic Projections (aka the “dot plot”) this week. As widely anticipated, the Fed upgraded its view on growth following the passage of the $1.9 trillion American Rescue Plan Act. The Fed now expects real GDP to rise by 6.5% in the fourth quarter of 2021 from a year ago, up from its December 2020 estimate of 4.2%. The Fed also sees the unemployment rate falling to 4.5% by the fourth quarter of this year. Back in December, the Fed thought the unemployment rate would end this year at 5% (Chart 1). Chart 1The Fed Sees Faster Recovery, Same Rate Path Is The Fed Locked Into A Low Interest-Rate Trap? Is The Fed Locked Into A Low Interest-Rate Trap? Chart 2The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed Has Been Lowering Its Estimate Of The Neutral Rate The Fed’s unemployment rate projection of 3.9% for 2022 is slightly below the “longer run” estimate of 4.0%. This suggests that the Fed believes the US will have reached full employment by the end of next year. Yet, despite the Fed’s sanguine view on the pace of the economic recovery, the median dot for the expected fed funds rate in 2023 remained at 0.1% (although seven members did pencil in a hike for that year, up from five last December). The median “longer run” dot stayed at 2.5%, with not a single Fed member putting in an estimate above 3%. The Fed regards this longer-run dot as its estimate of the neutral rate of interest – the interest rate consistent with full employment and stable inflation. When the Fed introduced the “dots” back in early 2012, its estimate of the neutral rate stood at 4.3%. It has been trending lower ever since (Chart 2). Explanations For The Falling Neutral Rate What accounts for the steady decline in the Fed’s estimate of the neutral rate in recent years? Fed officials have generally argued that structural forces have dragged down the equilibrium interest rate for the economy. These forces include slower trend growth, an aging population, the shift to a capital-lite economy, high levels of overseas savings, and as we recently discussed, increased income inequality. There is another interpretation, however. Rather than casting the Fed as a helpless observer responding to structural forces beyond its control, some commentators have argued that the Fed’s own actions explain why rates are so chronically low today. By cutting interest rates at every opportunity, so the argument goes, the Fed has inflated a massive asset bubble, stretching from equities to commercial real estate to cryptocurrencies. Moreover, low rates have encouraged governments and the private sector to take on more debt. Chart 3The Correlation Between Swings In Mortgage Rates And Housing Activity The Correlation Between Swings In Mortgage Rates And Housing Activity The Correlation Between Swings In Mortgage Rates And Housing Activity All this has locked the Fed into a low interest-rate trap: Any attempt to tighten monetary policy would cause asset prices to plunge and debt-servicing costs to rise. This would result in financial distress and rising unemployment – the exact two things the Fed wants to avoid. The Fed Is Not The Culprit It is a provocative argument, but is the Fed really to blame? For the most part, the answer is “’no.” To see why, consider the counterfactual: Suppose the Fed did not cut rates. If rates had stayed elevated, the recovery in the cyclical sectors of the economy following the Global Financial Crisis would have been even slower. Housing, in particular, would have remained in the doldrums. Chart 3 shows that there is a strong correlation between housing activity and the 30-year mortgage rate. Lower home prices would have reduced spending via the wealth effect channel, while making it more difficult for banks to recapitalize their balance sheets. In addition, relatively high US rates would have put upward pressure on the dollar, leading to a larger trade deficit (Chart 4). All of this would have reduced aggregate demand. Chart 4The Dollar And The Trade Balance The Dollar And The Trade Balance The Dollar And The Trade Balance Chart 5Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening The share of national income flowing to workers tends to rise when the labor market tightens (Chart 5). A chronic shortfall in aggregate demand would have exacerbated income inequality. Since the poor spend more of every dollar of disposable income than the rich, this would have further dampened overall spending. The Fed has been like a doctor administering a life-saving medicine that comes with some notable side effects. These side effects include increased sensitivity of asset prices to changes in interest rates.1 They also include higher debt levels, at least in those sectors of the economy that had the ability to lever up in response to lower interest rates. Side Effect Triage How dangerous are these side effects? To the extent that today’s low policy rates stem from the fact that structural forces have depressed the neutral rate of interest, they are not especially dangerous at the moment. Yes, debt-servicing costs would balloon, and asset prices would tumble, if the Fed raised rates significantly. However, there’s no reason for the Fed to do that in a setting where the neutral rate is very low. The problem is that the neutral rate may rise over time. Baby boomers are leaving the labor force en masse. They accumulated a lot of wealth while working. According to the Federal Reserve, they currently own more than half of all US wealth (Chart 6). In fact, Americans over the age of 55 controlled 70% of household wealth as of the third quarter of 2020, up from 54% in 1989. As baby boomers retire, their consumption will no longer be backed by income. The resulting depletion of savings will push up the equilibrium rate of interest. Chart 6Baby Boomers Have Accumulated A Lot Of Wealth Is The Fed Locked Into A Low Interest-Rate Trap? Is The Fed Locked Into A Low Interest-Rate Trap? While US fiscal policy will tighten next year, it will remain highly pro-cyclical by historic standards. BCA’s geopolitical strategists expect Congress to pass a $4 trillion spending bill this fall focusing on infrastructure, health care, and clean energy. They anticipate that only half of the bill will be financed through higher taxes. Big budget deficits will drain private-sector savings. There Will Be Political Pressure To Keep Rates Low Debt is not a major problem for governments when the interest rate they pay is below the growth rate of the economy. As we have discussed before, when trend GDP growth exceeds the borrowing rate, the more debt a government carries, the more fiscal support it can provide without putting the debt-to-GDP ratio on a runaway trajectory. If interest rates were to rise meaningfully, however, what had previously been a virtuous fiscal circle would become a vicious one. Needless to say, governments would resist such an outcome. Faced with the prospect of having to reallocate tax revenue from social programs to bondholders, politicians would put political pressure on central banks to refrain from raising rates. Central banks would probably oblige, at least initially. By keeping interest rates below their equilibrium level, central banks could engineer higher inflation – something they have been striving to do for quite some time. Higher inflation, in turn, could pave the way for an exit from the low interest-rate trap. Rising prices would lift nominal GDP, thereby reducing the debt-to-GDP ratio. As inflation rose, real rates would fall. This would provide relief to overextended private-sector borrowers. Once enough debt had been inflated away, central banks could bring interest rates to their equilibrium level. In the end, bondholders would suffer while borrowers would prosper. This leads us to our key macroeconomic conclusion: Today’s low interest-rate trap will likely be resolved through an extended period of easy money, ultimately culminating in significantly higher inflation. Investment Implications Equities face some near-term risks stemming from the recent rise in bond yields. Nevertheless, as we have argued in past reports, stocks will shrug off their losses provided that bond yields do not rise to a level that chokes off economic growth. With the Fed still on hold, we do not expect that to happen anytime soon. As such, our best bet is that the Goldilocks environment for risk assets – where growth is strong, inflation is contained, and monetary policy is accommodative – will last another two years. Investors operating on a 12-month horizon should continue to favor stocks over bonds. Within the fixed-income category, investors should overweight spread product relative to safer government bonds. Value stocks will lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech realm. The cessation of lockdown measures will favor value names. Not only is value still exceptionally cheap in relation to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year (Chart 7). Chart 7 Earnings Revisions And Valuations Favor Value Stocks (I) Earnings Revisions And Valuations Favor Value Stocks (I) Earnings Revisions And Valuations Favor Value Stocks (I) Chart 7Earnings Revisions And Valuations Favor Value Stocks (II) Earnings Revisions And Valuations Favor Value Stocks (II) Earnings Revisions And Valuations Favor Value Stocks (II) Recent upgrades to economic growth forecasts have favored the US, which could help the dollar in the near term. Nevertheless, we expect the greenback to fall modestly over a 12-month horizon. The US trade deficit has ballooned in recent quarters, while the dollar remains overvalued on a purchasing power parity basis (Chart 8). Despite improving US growth prospects, real yield differentials have not moved significantly in favor of the dollar (Chart 9). Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (I) Chart 8The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) The Dollar Is Expensive Based On Its PPP Fair Value And Growing Trade Deficit (II) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (I) Chart 9Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Real Yield Differentials Have Not Moved Significantly In Favor Of The Dollar (II) Moreover, the growth outlook outside the US should improve later this year as more countries ramp up their vaccination campaigns. US growth should also come down from its highs due to the expiration of various stimulus measures. Meanwhile, China will continue to stimulate its economy, albeit at a slower pace. Jing Sima, BCA’s chief China strategist, expects the rate of credit expansion to fall by only 2-to-3 percentage points in 2021. The general government deficit should remain broadly stable at 8% of GDP this year, ensuring adequate fiscal support for growth. A strong Chinese economy will bolster the RMB and other EM currencies. Looking further ahead, the cyclical bull market in stocks will end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major danger for the middle of the decade and beyond. As we discussed last week, inflation is often slow to rise in response to an overheated economy, but when it does rise, it can do so precipitously. Investors looking to hedge long-term inflation risk should reduce duration exposure in fixed-income portfolios while favoring inflation-protected securities over nominal bonds. In addition to gold, they should own some property. The best inflation hedge is simply to buy a nice house financed with a high loan-to-value fixed-rate mortgage. In a few decades you will still own the nice house, but the value of the mortgage will be greatly reduced in real terms.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 For example, suppose the earnings yield is 4% – as it approximately is now for global equities – and the real bond yield is zero, implying an equity risk premium (ERP) of 4%. A one percentage-point increase in real bond yields would require that stock prices fall by 20% in order to keep the ERP unchanged (e.g., the earnings yield would have to rise from 4/100=4% to 4/80=5%). In contrast, if the earnings yield were initially 7% and the real bond yield were 3%, stock prices would need to fall by only 12.5%, taking the earnings yield from 7/100=7% to 7/87.5=8%.   Global Investment Strategy View Matrix Is The Fed Locked Into A Low Interest-Rate Trap? Is The Fed Locked Into A Low Interest-Rate Trap? Special Trade Recommendations Is The Fed Locked Into A Low Interest-Rate Trap? Is The Fed Locked Into A Low Interest-Rate Trap? Current MacroQuant Model Scores Is The Fed Locked Into A Low Interest-Rate Trap? Is The Fed Locked Into A Low Interest-Rate Trap?

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Thursday, March 25 at 10:00 am EDT and Friday March 26 at 9:00 am HKT. I look forward to your comments and questions during the webcast. Best regards, Chester Highlights During bear markets, counter-trend rallies in the dollar are capped around 4%. This time should be no different. Meanwhile, unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real short rates will drop. The relative equity performance of the US is critical for the dollar. Reserve diversification out of dollars has also started to place a natural ceiling against other developed market currencies. An attractive opportunity is emerging to short the AUD/CAD cross. Feature The 1.7% rise in the US dollar this year is reinvigorating the bull case. When presenting our key views last year, we highlighted that the DXY index was at risk of a 2-4% bounce.1 We reaffirmed this view in our January report: Sizing A Potential Dollar Bounce. At the time, the DXY index was at the 90 level, suggesting the rally should fizzle around 94. Therefore, the key question is whether the nascent rise in the DXY will punch through this level, or fade as we originally expected. The short-term case for the dollar remains bullish. The currency is much oversold. Meanwhile, real interest rates are moving in favor of the US, vis-à-vis a few countries. Third and interrelated, economic momentum in the US is quite strong, compared to other G10 countries. With the rising specter of a market correction, the dollar could also benefit from safe haven flows towards the US. The Federal Reserve’s meeting yesterday certainly reaffirmed that short-term rates will remain anchored near zero, at least until 2023. The Fed does not see inflation much above 2% a couple of years out. Nevertheless, a lot can change in the coming months. Cycles, Positioning And Interest Rates The dollar tends to move in long cycles, with the latest bull and bear markets lasting about a decade or so. In other words, the dollar is a momentum currency. As such, determining which regime you are in is critical to assessing the magnitude of any rally. This is certainly the case when sentiment remains overly dollar bearish, as now. During bear markets, counter-trend rallies in the dollar are capped around 4-6%. This was what happened in the early 2000s. In bull markets, such as after the financial crisis, the dollar achieves escape velocity, with more durable rallies well into the teens (Chart I-1). So far, the current rise still fits within the narrative of a healthy reset in a longer-term bear market. Chart I-1The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign The Dollar Rally Is Still Benign Long interest rates have also been moving in favor of the dollar, especially relative to the euro area, Japan, and even Sweden. Currencies are driven by real interest rate differentials, and higher US yields are bullish. With the Fed giving no indication it will prevent the curve from steepening further, US interest rates could keep gaping higher. However, currencies are about relative rate differentials, and the rise in US interest rates has not been in isolation. Rates in the UK, Australia and New Zealand, countries that have managed the COVID-19 crisis pretty well, are beginning to rise faster than in the US (Chart I-2). Chart I-2A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields A Synchronized Rise In Global Yields US Versus World Growth The rise in US interest rates has been justified by better economic performance. Whether looking at purchasing managers’ indices, economic surprise indices, or even GDP growth expectations, the US has had the upper hand (Chart I-3). The Fed expects US growth to hit 6.5% this year. This is well above what other central banks expect for their domestic economies. The ECB expects 4%, the BoJ expects 3.9%, and the BoC expects 4.6% (Table I-1). Chart I-3AThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Chart I-3BThe US Leads In Growth This Year The US Leads In Growth This Year The US Leads In Growth This Year Table I-1The US Leads In Growth And Inflation This Year Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears However, economic dominance can be transient, especially in a world of flexible exchange rates.  For one, a higher dollar will sap US growth via the export channel. This is especially the case since the starting point is an expensive currency. On a real effective exchange rate basis, the dollar is above its long-term mean (Chart I-4). Meanwhile, we expect the rest of the world to perform better as economies reopen. The services PMI in the US is already close to a cyclical high, similar to Sweden (Chart I-5). These are among the countries with the least stringent COVID-19 measures in the western hemisphere. This suggests that other economies, even manufacturing-centric ones, could see a coiled-spring rebound in growth as we put this pandemic behind us. Chart I-4The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-5The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The US Service PMI Is At A Cyclical High The sweet spot for most economies is when growth is rising but inflation is low, allowing the resident central bank to keep policy dovish. However, it is an open question if the US can continue to boost spending, without a commensurate rise in inflation. The OECD estimates that the US output gap will close by 2022, with the $1.9-trillion fiscal package. This will put the US well ahead of any G10 country (Chart I-6). Unless the Fed tightens policy to stem the increase in aggregate demand, inflation will rise and real rates will drop (Chart I-7). Rising nominal rates and falling real yields will be anathema to the dollar. Chart I-6The US Output Gap Will Soon Close The US Output Gap Will Soon Close The US Output Gap Will Soon Close Chart I-7Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Wages And Inflation Should Inch Higher Equity Rotation And The Dollar A currency manager once noted that the most important variable to pay attention to when making FX allocations is relative equity performance. This might seem bizarre at first blush, but stands at the center of what an exchange rate is – a mechanism that equalizes rates of return across countries. As such while bond flows are important for exchange rates, equity flows matter as well. The relative equity performance of the US is critical for two reasons. First, the US equity market tends to do relatively better during bear markets. This was the case last year and during the 2008 crisis. Second, the outperformance of the US over the last decade has dovetailed with a dollar bull market (Chart I-8). It is rare to find a currency that has performed well both during equity bull and bear markets. If past is prologue, the near-term risks for the dollar are to the upside, especially if the market rally encounters turbulence as yields rise. The put/call ratio in the US is at a 5-year nadir. A move towards parity could violently pull up the DXY index (Chart I-9). However, a garden-variety 5-10% correction in the SPX should correspond to a shallow bounce in the DXY. This will also fit the pattern of bear market USD rallies, as we already highlighted in Chart I-1. Chart I-8US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar US Equity Relative Performance And The Dollar Chart I-9The Dollar Could Rise In ##br##A Market Reset The Dollar Could Rise In A Market Reset The Dollar Could Rise In A Market Reset At the same time, any correction could usher in a violent rotation from cyclicals to defensives, especially if underpinned by higher interest rates. The performance of energy and financials are a leap ahead of other sectors in the S&P 500 this year. Importantly, they also massively outperformed during the February drawdown. Meanwhile, valuations are heavily elevated in the US compared to the rest of the world. This is true for growth sectors compared to value, and cyclicals compared to defensives. Throughout history, both exchange rates and valuations have tended to mean revert. Long-Term Dollar Outlook The 2020 pandemic was a one-in-a-hundred-year event. Coordinated fiscal and monetary stimuli have ushered in a new economic cycle. As a counter-cyclical currency, the dollar tends to do poorly (Chart I-10). This is because monetary stimulus provides more torque to economies levered to the global cycle. Once growth achieves escape velocity, the currencies of these more pro-cyclical economies benefit. The IMF projects that non-US growth should outpace US growth after 2021. Meanwhile, it is an open question that any rally in the dollar will be durable. The key driver behind the dollar increase in 2020 was a global shortage. Not only has the Fed extended its liquidity provisions to foreign central banks until September this year, the share of offshore US dollar debt issuance has fallen by a full 9 percentage points (Chart I-11). Simply put, the Fed is flooding the system with dollar liquidity at the same time that foreign entities are weaning themselves off it Chart I-10The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 The IMF Expects Faster Growth Outside The US After 2021 Chart I-11Share Of US Dollar Debt ##br##Rolling Over Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears The reason behind this is balance-of-payment dynamics. The market has realized that ballooning twin deficits in the US come at a cost. For foreign issuers, it is the prospect of rolling over US-denominated debt at a much higher coupon rate. For bond investors, it is currency depreciation, especially if fiscal largesse becomes too “sticky,” and stokes inflation. As such, bond investors continue to avoid the US, despite rising rates (Chart I-12). Finally, reserve diversification out of dollars has started to place a natural ceiling on the US dollar, especially against other developed market currencies. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart I-13). This will place a durable floor under developed market currencies in general and gold in particular. The Chinese RMB has also been gaining traction in global FX reserves. Chart I-12Little Appetite For US ##br##Treasurys Little Appetite For US Treasurys Little Appetite For US Treasurys Chart I-13Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar Reserve Diversification Has Been A Headwind For The Dollar More specifically, the role of the USD/CNY exchange rate as a key anchor for emerging market currencies will rise, especially if the RMB remains structurally strong.2 The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. Swap agreements entail no exchange of currency, but are about confidence. The PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves. The dollar will remain the global reserve currency for years to come. However, a slow pivot towards reserve diversification will act as a structural headwind for the dollar. Housekeeping Chart I-14AUD/CAD Is Correlated To The VIX Arbitrating Between Dollar Bulls And Bears Arbitrating Between Dollar Bulls And Bears We were stopped out of our CAD/NOK trade for a profit of 3.1%. The resilience of the US economy is benefiting the CAD more than the NOK for now. However, the Norges Bank confirmed it might be one of the first central banks to lift rates, as early as this year. We are both short USD/NOK and EUR/NOK and recommend sticking with these positions. Second, the growing spat between the EU and the UK could lead to more volatility in our short EUR/GBP position. Our target remains 0.8, but we are tightening stops to 0.865 to protect profits. The BoE left interest rates unchanged, but struck a constructive tone. This will bode well for cable, beyond near-term volatility. Third, our short USD/JPY position was stopped out amid the dollar rally. We are standing aside for now, but will reopen this trade later. Finally, a rise in volatility will boost the dollar, but also benefit short AUD/CAD positions. We are already short the AUD/MXN, but short AUD/CAD could be more profitable should market turmoil persist (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see the Foreign Exchange Strategy Special Report, titled “2021 Key Views: Tradeable Themes,” dated December 4, 2020. 2 Please see Foreign Exchange Strategy Currency In-Depth Report, titled “Will The RMB Continue To Appreciate?,” dated February 26, 2021. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Most data out of the US has been robust: Both PPI, import and export prices were in line with expectations for February. The PPI ex food and energy came in at 2.5% year-on-year. Empire manufacturing was robust at 17.4 in March, versus 12.1 last month. Housing starts and building permits came in a nudge below expectations in February, at 1421K and 1682K. The one disappointment was retail sales, which fell 3.3% year-on-year in February. The DXY index rose slightly this week. The FOMC remained dovish, without any revision to its median path of interest rate hikes. The markets disliked its reticence on rising long-bond yields. As such, equities are rolling over as yields continue to creep higher. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area are mending: The ZEW expectations survey rose to 74 in March, from 69.6. For Germany, the improvement was better at 76.6 from 71.2. The trade balance remained at a healthy €24.2bn euro surplus in January. The euro fell by 0.6% amidst broad dollar strength. With the ECB committed to cap the rise in yields and rise in peripheral spreads, relative interest rates will move against the euro. Sentiment remains elevated, and so a healthy reset is necessary to wash out stale longs. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been mixed: Core machinery orders grew 1.5% year-on-year in January. Exports fell by 4.5% in January, while imports rose by 11.8%. This has shifted the adjusted trade balance to a deficit of ¥38.7bn yen. The Japanese yen fell by 0.4% against the US dollar this week, and remains the weakest G10 currency this year. Rising yields have seen Japanese investors stampede into overseas markets such as the UK, while pushing down the yen. We remain yen bulls, but will stand aside for now since it could still go lower in the short term. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been weak: Industrial production and construction output fell by 4.9% and 3% year-on-year in January. Monthly GDP growth fell by 2.9% in January. Rightmove house prices rose 2.7% year-on-year in March. The pound fell by 0.4% against the dollar this week. It however remains the best performing currency this year. The BoE kept monetary policy on hold, but struck a hawkish tone as vaccination progresses, giving way to higher mobility in the summer. We remain long sterling via the euro. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home prices rose by 3.6% in the fourth quarter. Modest home appreciation is welcome news by the RBA, given high-flying prices in its antipodean neighbor. The employment report was solid. There were 88.7K new jobs in February, all full-time. This pushed down the unemployment rate to 5.8% from 6.4%. The Aussie fell by 0.4% this week. The Australian recovery is fast approaching escape velocity, forcing the RBA to contain a more pronounced rise in long-bond yields. We remain long AUD/NZD. In the very near term, a market shakeout could pull the Aussie lower, favoring short AUD/CAD positions.  Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data out of New Zealand was weak: Credit card spending fell by 10.6% year-on-year in January. Q4 GDP contracted by 1% both year-on-year and quarter-on-quarter. The current account remains in deficit at NZ$-2.7bn for Q4. The New Zealand dollar fell by 0.9% against the US dollar this week. The new rule to include house prices in setting monetary policy will be a logistical nightmare for the RBNZ. In trying to achieve financial stability, the RBNZ will have to forego some economic stability, especially if the country still requires accommodative settings. Confused messaging could also introduce currency volatility. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 There was a data dump in Canada this week: The economy added 259.2K jobs in February. This pushed down the unemployment rate from 9.4% to 8.2%. Wages also increased by 4.3% in February. The Nanos confidence index rose from 60.5 to 62.7 in the week of March 12. Housing starts rose by 246K in February, as expected. The BoC’s preferred measures of CPI came in close to the 2% target. Headline CPI was weaker at 1.1% in February. The Canadian dollar rose by 0.3% against the US dollar this week. The correction in oil prices could set the tone for the near-term performance of the loonie, despite robust domestic conditions. However, at the crosses, CAD should have upside. We took profits on our short CAD/NOK position this week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: Producer and import prices fell by 1.1% year-on-year in February. February CPI releases also suggest the economy remains in deflation. The Swiss franc fell by 0.4% against the US dollar this week. Safe-haven currencies continue to be sold as yields rise, making the Swiss franc the worst performing currency this year after the yen. This is welcome news for the SNB.  We have been long EUR/CHF on this expectation, and recommend investors to stick with this trade. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The trade balance remained in surplus of NOK 25.1bn in February. The Norges bank kept interest rates on hold at 0%. The NOK fell by 1.2% against the dollar this week. The trigger was the selloff in oil prices. However, with the Norges bank signaling a rate hike later this year, placing it ahead of its G10 peers, there is little scope for the NOK to fall durably. Inflation in Norway is above target, and higher mobility later this year will benefit oil-rich Norway. We are long the Norwegian krone as a high-conviction bet against both the dollar and the euro. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data releases were a slight miss: Headline CPI came in at 1.4% in February. Core CPI came in at 1.2%. The unemployment rate remained at 8.9% in February. The Swedish krona fell by 0.8% against US dollar this week. Sweden is struggling to contain another wave of the pandemic and this has weighed on the currency this year. The saving grace for the economy has been a global manufacturing cycle that continues humming. Until Sweden is able to get past the pandemic, the currency will continue trading in a stop-and-go pattern. We remain long the SEK on cheap valuations and as a play on the global industrial cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 1Biden’s Tax Hike Proposals On The Campaign Trail Building Back … The Wall Of Worry Building Back … The Wall Of Worry Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) Building Back … The Wall Of Worry Building Back … The Wall Of Worry For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening Building Back … The Wall Of Worry Building Back … The Wall Of Worry The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark China Policy Overtightening Benchmark China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge Building Back … The Wall Of Worry Building Back … The Wall Of Worry China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China Building Back … The Wall Of Worry Building Back … The Wall Of Worry The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China EU Risk Averse On China EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce Building Back … The Wall Of Worry Building Back … The Wall Of Worry As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 4BGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling German Party Polling German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Building Back … The Wall Of Worry Building Back … The Wall Of Worry Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.