Sectors

Highlights The selloff in crypto-currencies on May 19 may be overblown but the risk of government intervention is a rising headwind for this asset class. While environmental concerns are a threat to Bitcoin, the entire crypto-currency complex faces a looming confrontation over governance. Digital currencies are a natural evolution of money following coinage and paper. Moreover a sizable body of consumers is skeptical of governments and traditional banking. Loose monetary conditions are fueling a speculative mania. However, governments fought for centuries to gain a monopoly over money. As crypto-currencies become more popular, governments will step in to regulate and restrict them. Central bank digital currencies (CBDCs) threaten to remove the speed and transactional advantage of crypto-currencies, leaving privacy/anonymity as their main use-case. Feature The prefix “crypto” derives from the Greek kruptos or “hidden.” This etymology highlights one of the biggest problems confronting the crypto-currency craze in financial markets today. Speed and anonymity are the greatest assets of the digital tokens. But the former advantage is being eroded by competitors while the latter is becoming a political liability. In the 2020s, governments are growing stronger and more interventionist, not weaker and more laissez faire. Chart 1Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Loose Money Fuels Crypto Mania Bitcoin and rival crypto-currency Ethereum fell by 29.5% and 43.2% in intra-day trading on May 19, only to finish the day down by 13.8% and 27.2%, respectively. The market panicked on news that China’s central bank had banned firms from handling transactions in crypto-currencies. What really happened was that China’s National Internet Finance Association, China Banking Association, and Payment and Clearing Association issued a statement merely reiterating a 2013 and 2017 policy that already banned firms from handling transactions in crypto-currencies. These three institutions also warned about financial speculation regarding crypto-currencies.1 The crypto market suffered a spike in volatility because it is in the midst of a speculative mania. In the last five years, total market capitalization of crypto-currencies has risen from around $7 billion to $2.3 trillion,2 recording a 34,000% gain. Some crypto-currencies have even recorded returns in excess of that number over a shorter horizon. Price gains have been driven by retail buyers who may or may not know much about this new asset class (Chart 1). Prior to the May 19 selloff, prices had grown overextended and recent concerns over the environment, sustainability, and governance (ESG) had shaken confidence in Bitcoin and its peers. Chinese authorities have already banned financial firms from providing crypto services in a bid to deter ownership of crypto-currencies. And China is not alone. The latest market jitters are a warning sign that government interference in the crypto-currency market is a real threat. Regulation and sovereign-issued digital currencies are starting to enter the fray. While ultra-dovish central bank policies are not changing soon, and therefore crypto-currency price bubbles can continue to grow, crypto-currencies will remain subject to extreme volatility and precipitous crashes. In this report we argue that the fundamental problem with crypto-currencies is that they threaten the economic sovereignty of nation-states. Environmental degradation, financial instability, and black market crime, and other concerns about cryptos have varying degrees of merit. But they provide governments with ample motivation to pursue a much deeper interest in regulating a technological innovation that has the power to undermine state influence over the economy and society. Government scrutiny is a legitimate reason for crypto buyers to turn sellers. Does The World Need Crypto-Currencies? Broadly speaking, there are two primary justifications for crypto-currencies, centered on a transactional basis: speed and privacy/anonymity. The crux of crypto-currency creation rests on these two use cases.3 The speed of crypto-currencies comes from their ability to increase efficiency in local and global payment systems by facilitating financial transactions without the need of a third party (e.g. a financial institution). Cross-border settlement of traditional (fiat) currency transactions processed through the standard SWIFT communications system takes up to two business days. Most transactions involving crypto-currencies over a blockchain network are realized in less than an hour, cross-border or not.4 The fees involved with third-party payments are often more expensive than transacting with crypto-currencies. Simply put, excluding the “middleman” can save money. This is a selling point in a global market that expects to see retail cross-border transactions reach $3.5 trillion by the end of 2021, of which up to 5% are associated with transaction-based fees.5 But this breakthrough in payment system technology can be overstated and is not the main reason for using crypto-currency. Speculation drives current use, especially given that there is speculative behavior even among those who believe that cryptos are safe-haven assets or promising long-term investments (Chart 2). Chart 2Crypto-Currency Use Driven By Speculation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 3Consumers Growing Skeptical Of Banking Regulation Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide If a person wants to buy an item from a company in a distant country, that person could use a crypto-currency just as he or she could use a credit card. Both parties would have a secure medium of exchange but, unlike with a credit card, both would avoid using fiat currencies. Neither party could conduct the same transaction using gold or silver. The crucial premise is the existence of an online community of individuals and firms who for one reason or another want to avoid fiat currencies. From a descriptive point of view, the crypto-currency phenomenon implies a lack of trust in modern governments, or at least their monetary systems, and an assertion of individual property rights. The list of crypto-currencies continues to grow. To date, there are approximately 9,800 of them. Some are trying to prove their economic value or use, while others have been created with no intended purpose or problem to solve. Even so, there has yet to be a crypto-currency that overwhelms the use of slower fiat money. In a recent Special Report, BCA Research’s Foreign Exchange Strategist Chester Ntonifor showed that crypto-currencies still have a long way to go to have a chance at replacing fiat monies. While crypto-currencies are showing signs of significant improvement as mediums of exchange, they still fall short as stores of value and units of account. The other primary case for crypto-currencies is privacy or anonymity. The bypassing of intermediaries implies a greater control of funds by the two parties of a transaction. Crypto-currencies are said to be more “private” compared to fiat money. Fiat money is controlled by governments and banks while crypto-currencies have only “owners.” Crypto-currencies are anonymous because they are stored in digital wallets with alphanumeric sequences – there is a limited personal data trail that follows crypto-currency compared to those of electronic fiat currency transactions. In a post-9/11, post-GFC, post-COVID world where a sizable body of consumers is growing more skeptical of government surveillance and regulation and banking industry practices (Chart 3), crypto-currencies give users more than just a means to transact with. However, privacy is not the same as security. Hacking and fraud can affect cryptos as well as other forms of money and attacks will increase with the value of the currencies. Bitcoin At The Helm Of Crypto-Currency Market Chart 4Bitcoin Slows Bitcoin Slows Bitcoin Slows Bitcoin has cemented its status as the number one currency in the crypto-verse.6 It is considered to be the first crypto-currency created, it is the most widely accepted, it is touted as a store of value or “digital gold,” and it is the most featured in quoting alternative crypto-currency pairs across crypto exchanges. As it stands, Bitcoin accounts for around 42% of total crypto-currency market capitalization.7 This share has declined from around 65% at the start of 2021 on the back of the frenzied rise of several alternative coins.8 But rising risks to Bitcoin’s standing will cause the entire crypto-market to retreat. In a Special Report penned in February, BCA Research’s Chief Global Strategist Peter Berezin argued that Bitcoin is more of a trend than a solution and that its usefulness is diminishing. Bitcoin’s transaction speed is slowing and its transaction cost is rising (Chart 4). Slowing speed and rising cost on the Bitcoin network are linked to a scalability problem. The crypto-currency’s network has a limited rate at which it can process transactions related to the fact that records (or “blocks”) in the Bitcoin blockchain are limited in size and frequency. This means that one of its fundamental justifications, transactional speed, will become less attractive over time, should the network not address these issues. Bitcoin also consumes a significant amount of energy, a controversy that is gaining traction in the crypto-currency market after Elon Musk, the “techno-king” of Tesla, cited environmental concerns in reversing his decision to accept Bitcoin payment for his company’s electric vehicles. Energy consumption rises as more coins are mined, since mining each new Bitcoin becomes more computer-power intensive. The need for computing power and energy will continue to increase until all 21 million Bitcoins (total supply) are mined, which is currently estimated to occur by the year 2140. Strikingly, the energy needed to mine Bitcoin over a year are comparable to a small country’s annual power consumption, such as Sweden or Argentina (Chart 5). Chart 5Bitcoin Consumes More Energy Than A Small Country … Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin also generates significant quantities of electronic waste (Chart 6). Chart 6… And Generates A Lot Of Electronic Waste Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin mining is heavily domiciled in China, which accounts for 65% of global mining activity (Figure 1). China’s energy mix is dominated by coal power, which makes up approximately 65% of the country’s total energy mix even after a decade of aggressive state-led efforts to reduce coal reliance. Of this, coal powered energy makes up approximately 60% of Bitcoin’s energy mix in China.9 With several countries aiming to minimize carbon emissions, and with approximately 60% of Bitcoin mining powered by coal-fired energy globally,10 Bitcoin imposes a major negative environmental impact. Figure 1Bitcoin Mining Well Anchored In Asia Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Bitcoin does not shape up well when compared to gold’s energy intensity either. Bitcoin mining now consumes more energy than gold mining over a single year. While the energy difference is not large, the economic value is. Gold’s energy consumption to economic value trade-off is lower than that of Bitcoin. The production value of gold in 2020 was close to $200 billion, while Bitcoin was measured at less than $25 billion (Chart 7A). On a one-to-one basis, gold even has a lower carbon footprint than Bitcoin (Chart 7B). Chart 7AGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 7BGold Outshines Bitcoin On Production Value And Carbon Footprint Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Crypto-currency energy consumption and carbon footprint will attract the attention of government regulators. Of course, not all crypto-currencies are heavy polluters. But if the supply of cryptos is constrained by mining difficulties then they will require a lot of energy. If the supply is not constrained then the price will be low. Government Regulation Is Coming Environmental concerns point to the single greatest threat to crypto-currencies – the Leviathan, i.e. the state. In this sense the crypto market’s wild fluctuations on May 19, at the mere whiff of tougher Chinese regulation, are a sign of what is to come. Governments around the world have so far left crypto-currencies largely unregulated but this laissez-faire attitude is already changing. Environmental regulation has already been mentioned. Governments will also be eager to expand their regulatory powers to “protect” consumers, businesses, and banks from extreme volatility in crypto markets. But investors will underrate the regulatory threat if they focus on these issues. At the most basic level, governments around the world will not sit idly by and lose what could become significant control of their monetary systems. The ability to establish and control legal tender is a critical part of economic sovereignty. Governments won control of the printing press over centuries and will not cede that control lightly. If crypto-currencies are adopted widely, then finance ministries and central banks will lose their ability to manipulate the money supply and the general level of prices effectively. Politicians will lose the ability to stimulate the economy or keep inflation in check. Most importantly, while one may view such threats as overblown, it is governments, not other organizations, that will make the critical judgment on whether crypto-currencies threaten their sovereignty. Throughout the world, most crypto-currency exchanges are regulated to prevent money laundering. Crypto-currencies are not legal tender and, aside from Bitcoin, their use is mostly banned in China (Table 1). However, more specialized regulation that targets energy and economic use has yet to be brought into law across the world. Table 1World Governments Will Not Relinquish Hard-Fought Monopolies Over Money Supply Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In China, initial coin offerings (ICOs – the equivalent of an initial public offering on the stock market) and trading platforms are banned from engaging in exchanges between the yuan and crypto-currencies or tokens. In fact, China recognizes crypto-currencies only as virtual commodities or virtual property. India is another country where exchanges and ICOs are banned. While crypto-currencies are not banned, they are not legal tender. Indian policymakers have recently proposed banning crypto-currencies, however. The proposed legislation is one of the world’s strictest policies against crypto-currencies. It would criminalize possession, issuance, mining, trading, and transferring crypto-assets. If the ban becomes law, India would be the first major economy to make holding crypto-currency illegal. Even China, which has banned mining and trading, does not penalize possession. In the US, Secretary of the Treasury Janet Yellen has already expressed concerns regarding the illicit use of cryptos for supposed criminal gain.11 She is in alignment with European Central Bank President Christine Lagarde. Because of the anonymity of crypto-currencies, identifying users behind illicit transactions is difficult. This means regulators face headwinds in identifying transactions that are made for criminal gain, as compared to fiat transactions. Governments have long dealt with the anonymity of cash but they have ways of monitoring bank accounts and paper bills. Crypto-currencies are beyond their immediate sight of control and therefore will attract growing scrutiny and legislative action in this regard. The Colonial Pipeline ransomware attack on May 7, which temporarily shuttered about 45% of the fuel supply line for the eastern United States, illustrates the point. The DarkSide group of hackers who orchestrated the attack demanded a ransom payment of $4.4 million worth of Bitcoin, which Colonial Pipeline paid them on May 7. Shortly thereafter, unspecified “law enforcement agencies” clawed back the $4.4 million from the hackers’ account (transferring it to an unknown address) and DarkSide lost access to its payment server, DOS servers, and blog. This episode should not be underrated. It was a successful, large-scale cyber-attack on critical infrastructure in the world’s most powerful country. It highlighted the illicit uses to which crypto-currencies can be put. True, criminals demand ransoms in fiat money as well – and many crypto-currency operators will distance themselves from the criminal underworld. Nevertheless governments will give little slack to an emerging technology that presents big new law enforcement challenges and is not widely used by the general public. Ultimately governments will pursue their sovereign interests in controlling money, the economy, and trade, listening to their banking lobby, expanding their remit to “protect” consumers, and cracking down on illicit activity. Governments are not capable of abolishing crypto-currencies altogether, or the underlying technology of blockchain. But they will play a large and growing role in regulating them. Central Banks Advancing On Digital Currencies Central bank digital currencies (CBDCs) will leave crypto-currencies in the realm of speculative assets. CBDCs are a form of digital money denominated in a country’s national unit of account and represent a liability on a central bank’s balance sheet. This is different from current e-money that represents a claim on a private financial institution’s balance sheet. It is also different from crypto-currencies, because there is a central authority behind a CBDC, unlike with crypto-currencies due to their decentralized nature. In China, the People’s Bank of China (PBoC) has suggested its rollout of a digital yuan is “ready” despite no release to date. Beta testing is ongoing in several provinces. The PBoC’s justification for a digital yuan comes from China’s growing cashless economy. The transition away from cash is largely thanks to mobile payment platforms like Alibaba’s Alipay and Tencent’s WeChat Pay, which, between the two of them, control almost the entire mobile payments market of some 850 million users. There is a significant amount of systemic risk in this system – one reason why Chinese authorities have recently subjected these companies to new scrutiny and regulation. Should Alibaba or Tencent go bankrupt, the local payment system will crash. The PBoC’s efforts will increase competition in the local payments space and reduce this systemic risk. Policymakers are also concerned that as Chinese citizens choose to hold their money in digital wallets provided by Alibaba and Tencent instead of bank accounts, liquidity is being drained from the traditional banking system, putting deposit levels at banks under strain, and posing risks to liability matching. The digital yuan will still involve a third party, unlike crypto-currencies which do not. Doing away with commercial banks is not a reality – indeed the Chinese Communist Party seeks to buttress the state-owned commercial banks in order to maintain control of the economy. What the digital yuan does, and other CBDCs will do too, is utilize blockchain technology, which is faster and more secure than traditional payment networks. In the US, the Fed has been studying the viability of a CBDC US dollar. The Fed has stated that it is carefully exploring whether a CBDC will lead to “safer, less expensive, faster, or otherwise more efficient payments.” While the Fed has yet to find a single standout case for a CBDC US Dollar, Fed Chair Jerome Powell said last year that the US has a “competitive payments market” with “fast and cheap services, particularly in comparison to other nations exploring a CBDC.” To date, the Fed’s observation is that many of the challenges that CBDCs hope to address do not apply to the US, including disuse of physical cash, narrow reach or high concentration of banking, and weak infrastructure for payment systems. Rather, the Fed is more focused on developing the FedNow real-time payment system for private banks. This is much the same as in Europe, where physical cash still plays a major role in day-to-day economic activity and where local payment systems are fast and secure. But central banks around the world continue to engage in work centered around CBDCs (Charts 8A and 8B) – and China’s progress will encourage others to move faster. Advanced economies are mostly interested in creating a safer and more efficient payment system, while emerging and developed economies have interest across several areas such as financial stability, monetary policy setting, and inclusiveness of banking, as well as efficiency and safety (Chart 9). CBDCs are especially attractive to emerging market policy makers at targeting those who lack access to traditional banking. Chart 8ACentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 8BCentral Banks Advancing On CBDC Work Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide Chart 9Central Banks CBDC Interest Areas Cryptocurrencies: They Can Run But They Can’t Hide Cryptocurrencies: They Can Run But They Can’t Hide In remote areas, access to banking is scarce and expensive. CBDCs can help solve this problem. Individuals would have CBDC accounts directly on a central bank ledger. They could then access their money and transact through a digital wallet application that is linked to the CBDC account. Giving people access to digital currency would allow them to transact quickly, in remote settings, without the need of hard currency. Monetary policy transmission is also better in advanced economies. In emerging markets, there are bottlenecks in local financial markets. Looser central monetary policy does not always translate into cheaper financing across the economy. In remote and poverty stricken areas, monetary policy transmission is sticky, meaning high costs of borrowing can persist even through accommodative policy cycles. This is a smaller issue in advanced economies. Payment systems in advanced economies are due an overhaul in security and efficiency, and CBDCs and blockchain technology will provide this. CBDCs will prove to be just as efficient to transact with as any crypto-currencies available today. CBDCs will also be legal tender and accepted by all vendors. The anonymity factor will be lost but this will not be a problem for most users (whereas legal issues will become a problem for crypto-currencies). The probability of central banks issuing CBDCs in both the short and medium term, both in the retail and wholesale space, is rising. If advanced economies like those of the G7 issue CBDCs soon, policy makers will undoubtedly ensure the use of it over the currently circulating and partially accepted crypto-currencies. The endgame will leave crypto-currencies in the highly speculative asset class, perhaps even in the black market where anonymity is valued for transactions that wish not to be tracked. Investment Takeaways Prices of crypto-currencies may continue to rise given sky-high fiat money creation amid the COVID pandemic and ultra-low interest rates. Digitalization is the natural next step in the evolution of money from precious metals to paper banknotes to electronic coin. But the market leader, Bitcoin, is encountering more headwinds. The primary case for the use of Bitcoin is challenged due to slowing transaction speeds and rising transaction costs. The virtual currency is primarily mined using coal-powered energy, resulting in growing scrutiny from governments and consumers. Government regulation is entering the ring and policymakers will take an increasingly heavy-handed role in trying to ensure that cryptos do not undermine economic sovereignty, financial stability, and law and order. When central banks begin to rollout digital currencies, especially those domiciled in advanced economies, crypto-currencies as medium of exchange will lose much of their allure. Crypto-currencies will remain as anti-fiat currencies and speculative assets. Risks To The View Given the controversy surrounding crypto-currencies, it is only fair to state outright the risks to our view. We would also recommend clients read our colleague Dhaval Joshi’s latest bullish take on Bitcoin. First, scaling up Bitcoin’s network and processing transactions in batches instead of single transactions will resolve transaction time and cost risks, restoring efficiency. This is a clear solution to efficiency concerns. However, scaling and batching transactions are not on the immediate horizon of Bitcoin developers. Bitcoin’s network will still need to undergo another “halving” in order for this risk to subside and for the network to scale. A halving of the network will only occur again in 2024.12 Second, on the environment: Bitcoin mining is not solely dependent on fossil fuel energy that gives it a “dirty” footprint. Renewables already make up some 25% of Bitcoin mining. Increasing the use of renewables in Bitcoin’s energy mix will help lower its environmental impact. However, this is easier said than done. Global renewable energy has yet to scale up to a point where it can consistently out-supply existing fossil-fuel energy. Mining hardware also has its associated carbon footprint that would need to be addressed. And location matters too. Crypto-currency mining farms are large-scale projects. Simply uprooting operations to a country that could lower the carbon footprint of a mining farm or two is not viable due to the costs involved. Hence crypto-currency mining will probably continue to be a “dirty” operation but a rapid shift to renewables would challenge our thesis. Bitcoin’s network is also based off a “proof of work” protocol. Miners must prove that a certain amount of computational effort has been expended for confirming blocks on the network, allowing transactions to be processed. Proof of work is energy intensive. Other crypto-currencies, like Ethereum, will adopt a “proof of stake” protocol. Simply put, transactions are confirmed by users and their stake in the associated crypto-currency. Proof of stake is less energy intensive compared to proof of work. Third, as to government regulation, the longer policymakers take to enact legislation targeting crypto-currencies, the larger their market will grow. Regulation in China and India may set a benchmark for major economies but not all will follow in the Asian giants’ footsteps. Some governments have been slow to study crypto-currencies, meaning legislation aimed at governing or regulating them may still be long in coming. Innovation is a good thing and free economies will not wish to restrain crypto-currencies or blockchain technology unduly, for fear of missing out. Fourth, on CBDCs, some central banks may only adopt them based on their respective economic needs. However, rising crypto-currency populism drives associated economic risks which can force the hands of central banks to adopt CBDCs in lieu of said needs. Each country faces unique challenges. Some central banks may not want to be left behind even if they believe their policy framework is facilitating economic activity efficiently. While the Fed has stated that it will not adopt a CBDC for the primary reason of ensuring payment security since it believes it already has a safe system in place, this view will change. The Fed could justify a move to a CBDC US dollar on the single basis of transitioning to a more sophisticated technology for the future. The Fed will not want to be caught behind the curve considering the PBoC is priming its digital yuan for release soon. Technological leadership is a strategic imperative of the United States and that imperative applies to financial technology as well as other areas.   Guy Russell Research Analyst GuyR@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Muyao Shen, “China Reiterates Crypto Bans From 2013 and 2017”, coindesk, May 18, 2021, coindesk.com. 2 As of May 11, 2021. 3 There are several other reasons or “problems” that crypto-currencies are created for or to solve, but speed and privacy form the basis of crypto-currencies first coming into existence. 4 Not all crypto-currencies transact in less than an hour. But there are many that transact in several minutes and in some cases, mere seconds. As the leading crypto-currency, Bitcoin takes approximately one hour for a transaction to be fully verified over its network. 5 “McKinsey’s Global Banking Annual Review”, McKinsey, Dec. 9, 2020, mckinsey.com. 6 We use Bitcoin as an example to understand the risk and impact of forthcoming government regulation and competition. Because of Bitcoin’s status, any significant risks that threaten the crypto-currency’s standing as the number one currency will threaten the entire market. 7 As of May 20, 2021. Figure varies daily. See www.coinmarketcap.com for more information. 8 Alternative currencies such as Ethereum, Ripple, Binance Coin, Dogecoin, and Cardano have chipped away at Bitcoin’s crypto-market dominance through 2021. 9 According to The Center For Alternative Finance, The University Of Cambridge. 10 According to The Center For Alternative Finance, The University Of Cambridge. 11 Data on the use of crypto-currencies for illicit activitiessays otherwise. Of all crypto-currency transactions, it is estimated that only 2.1% are used for illicit activities. See “2021 Crypto Crime Report”, Chainalysis, chainalysis.com. 12 A Bitcoin halving is when the reward for mining Bitcoin transactions is cut in half. This event also cuts Bitcoin's inflation rate and the rate at which new Bitcoins enter circulation, in half. Bitcoin last halved on May 11, 2020.

Highlights Global oil markets will remain balanced this year with OPEC 2.0's production-management strategy geared toward maintaining the level of supply just below demand.  This will keep inventories on a downward trajectory, despite short-term upticks due to COVID-19-induced demand hits in EM economies and marginal supply additions from Iran and Libya over the near term. Our 2021 oil demand growth is lower – ~ 5.3mm b/d y/y, down ~ 800k from last month's estimate – given persistent weakness in realized consumption.  We have lifted our demand expectation for 2022 and 2023, however, expecting wider global vaccine distribution and increased travel toward year-end. The next few months are critical for OPEC 2.0: The trajectory for EM demand recovery will remain uncertain until vaccines are more widely distributed, and supply from Iran and Libya likely will increase this year.  This will lead to a slight bump in inventories this year, incentivizing KSA and Russia to maintain the status quo on the supply side. We are raising our 2021 Brent forecast back to $63/bbl from $60/bbl, and lifting our 2022 and 2023 forecasts to $75 and $78/bbl, respectively, given our expectation for a wider global recovery (Chart of the Week). Feature A number of evolving fundamental factors on both sides of the oil market – i.e., lingering uncertainty over the return of Iranian and Libyan exports and the strength of the global demand recovery – will test what we believe to be OPEC 2.0's production-management strategy in the next few months. Briefly, our maintained hypothesis views OPEC 2.0 as the dominant supplier in the global oil market. This is due to the low-cost production of its core members (i.e., those states able to attract capital and grow production), and its overwhelming advantage in spare capacity, which we reckon will average in excess of 7mm b/d this year, owing to the massive production cuts undertaken to drain inventories during the COVID-19 pandemic. Formidable storage assets globally – positioned in or near refining centers – and well-developed transportation infrastructures also support this position. We estimate core OPEC 2.0 production will average 26.58mm b/d this year and 29.43mm b/d in 2022 (Chart 2). Chart of the WeekBrent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Brent Prices Likely Correct Then Move Higher in 2022-23 Chart 2OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo OPEC 2.0 Will Maintain Status Quo The putative leaders of the OPEC 2.0 coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have distinctly different goals. KSA's preference is for higher prices – ~ $70-$75/bbl (basis Brent) to the end of 2022. Higher prices are needed to fund the Kingdom's diversification away from oil. Russia's goal is to keep prices closer to the marginal cost of the US shale-oil producers, who we characterize as the exemplar of the price-taking cohort outside OPEC 2.0, which produces whatever the market allows. This range is ~ $50-$55/bbl. The sweet spot that accommodates these divergent goals is on either side of $65/bbl for this year. OPEC 2.0 June 1 Meeting Will Maintain Status Quo With Brent trading close to $70/bbl, discussions in the run-up to OPEC 2.0's June 1 meeting likely are focused on the necessity to increase the 2.1mm b/d being returned to the market over the May-July period. At present, we do not believe this will be necessary: Iran likely will be returning to the market beginning in 3Q21, and will top up its production from ~ 2.4mm b/d in April to ~ 3.85mm b/d by year-end, in our estimation. Any volumes returned to the market by core OPEC 2.0 in excess of what's already been agreed going into the June 1 meeting likely will come out of storage on an as-needed basis. Libya will likely lift its current production of ~ 1.3mm b/d close to 1.5mm b/d by year end as well. We are expecting the price-taking cohort ex-OPEC 2.0 to increase production from 53.78mm b/d in April to 53.86mm b/d in December, led by a 860k b/d increase in US output, which will take average Lower 48 output in the US (ex-GOM) to 9.15mm b/d by the end of this year (Chart 3). When we model shale output, our expectation is driven by the level of prompt WTI prices and the shape of the forward curve. The backwardation in the WTI forward curve will limit hedged revenues at the margin, which will limit the volume growth of the marginal producer. We expect global production to slowly increase next year, and the year after that, with supply averaging 101.07mm b/d in 2022 and 103mm b/d in 2023.  Chart 3US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 US Crude Output Recovers, Then Tapers in 2023 Demand Should Lift, But Uncertainties Persist We expect the slowdown in realized DM demand to reverse in 2H21, and for oil demand to continue to recover in 2H21 as the US and EU re-open and travel picks up. This can be seen in our expectation for DM demand, which we proxy with OECD oil consumption (Chart 4). EM demand – proxied by non-OECD oil consumption – is expected to revive over 2022-23 as vaccine distribution globally picks up. As a result, demand growth shifts to EM, while DM levels off. China's refinery throughput in April came within 100k b/d of the record 14.2mm b/d posted in November 2020 (Chart 5). The marginal draw in April stockpiles could also signify that as crude prices have risen higher, the world’s largest oil importer may have hit the brakes on bringing oil in. In the chart, oil stored or drawn is calculated as the difference between what is imported and produced with what is processed in refineries. With refinery maintenance in high gear until the end of this month, we expect product-stock draws to remain strong on the back of domestic and export demand. This will draw inventories while maintenance continues. Chart 4EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 EM Demand Will Recovery Accelerates in 2022-23 Chart 8China Refinery Runs Remain Strong China Refinery Runs Remain Strong China Refinery Runs Remain Strong COVID-19-induced demand destruction remains a persistent risk, particularly in India, Brazil and Japan. This is visible in the continued shortfall in realized demand vs our expectation so far this year. We lowered our 2021 oil demand growth estimate to ~ 5.3mm b/d y/y, which is down ~ 800k from last month's estimate, given persistent weakness in realized consumption. Our demand forecast for 2022 and 2023 is higher, however, based on our expectation for stronger GDP growth in EM economies, following the DM's outperformance this year, on the back of wider global vaccine distribution year-end (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Our supply-demand estimates continue to point to a balanced market this year and into 2022-23 (Chart 6). Given our expectation OPEC 2.0's production-management strategy will remain effective, we expect inventories to continue to draw (Chart 7). Chart 6Markets Remained Balanced Markets Remained Balanced Markets Remained Balanced Chart 7Inventories Continue To Draw Inventories Continue To Draw Inventories Continue To Draw CAPEX Cuts Bite In 2023 In 2023, we are expecting Brent to end the year closer to $80/bbl than not, which will put prices outside the current range we believe OPEC 2.0 is managing its production around (Chart 8). We have noted in the past continued weakness in capex over the 2015-2022 period threatens to leave the global market exposed to higher prices (Chart 9). Over time, a reluctance to invest in oil and gas exploration and production prices in 2024 and beyond could begin to take off as demand – which does not have to grow more than 1% p.a. – continues to expand and supply remains flat or declines. Chart 8By 2023 Brent Trades to /bbl By 2023 Brent Trades to $80/bbl By 2023 Brent Trades to $80/bbl Chart 9Low Capex Likely Results In Higher Prices After 2023 OPEC 2.0's Production Strategy In Focus OPEC 2.0's Production Strategy In Focus Bottom Line: We are raising our 2021 forecast back to an average of $63/bbl, and our forecasts for 2022 and 2023 to $75 and $78/bbl. We expect DM demand to lead the recovery this year, and for EM to take over next year, and resume its role as the growth engine for oil demand. Longer term, parsimonious capex allocations likely result in tighter supply meeting slowly growing demand. At present, markets appear to be placing a large bet on the buildout of renewable electricity generation and electric vehicles (EVs). If this does not occur along the trajectory of rapid expansion apparently being priced by markets – i.e., the demand for oil continues to expand, however slowly – oil prices likely would push through $80/bbl in 2024 and beyond.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish The Colonial Pipeline outage pushed average retail gasoline prices in the US to $3.03/gal earlier this week, according to the EIA. This was the highest level for regular-grade gasoline in the US since 27 October 2014. According to reuters.com, the cyberattack that shut down the 5,500-mile pipeline was the most disruptive on record, shutting down thousands of retail service stations in the US southeast. Millions of barrels of refined products – gasoline, diesel and jet fuel – were unable to flow between the US Gulf and the NY Harbor because of the attack, which was launched 7 May 2021 (Chart 10). While most of the system is up and running, problems with the pipeline's scheduling system earlier this week prevented a return to full operation. Base Metals: Bullish Spot copper prices remained on either side of $4.55/lb (~ $10,000/MT) by mid-week following a dip from the $4.80/lb level (Chart 11). We remain bullish copper, particularly as political risk in Chile rises going into a constitutional convention. According to press reports, the country's constitution will be re-written, a process that likely will pave the way for higher taxes and royalties on copper producers.1 In addition, unions in BHP mines rejected a proposed labor agreement, with close to 100% of members voting to strike. In Peru, a socialist presidential candidate is campaigning on a platform to raise taxes and royalties. Precious Metals: Bullish According to the World Platinum Investment Council, platinum is expected to run a deficit for the third consecutive year in 2021, which will amount to 158k oz, on the back of strong demand. Refined production is projected to increase this year, with South Africa driving this growth as mines return to full operational capacity after COVID-19 related shutdowns. Automotive demand is leading the charge in higher metal consumption, as car makers switch out more expensive palladium for platinum to make autocatalysts in internal-combustion vehicles. Ags/Softs: Neutral Corn prices continued to be better-offered following last week's WASDE report, which contained the department's first look at the 2021-22 crop year. Corn production is expected to be up close to 6% over the 2020-21 crop year, at just under 15 billion bushels. On the week, corn prices are down ~ 15.3%. Chart 10 RBOB Gasoline at a High RBOB Gasoline at a High Chart 11 Political Risk in Chile and Peru Could Bolster Copper Prices Political Risk in Chile and Peru Could Bolster Copper Prices     Footnotes 1     Please see Copper price rises as Chile fuels long-term supply concerns published 18 May 2021 by mining.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Neutral Revisiting Home Improvement Retailers Revisiting Home Improvement Retailers Home improvement retailers (HIR) were among the lucky ones that were allowed to keep their doors open during the pandemic. As a result, these big box retailers benefitted from the lockdown as people used their stimulus checks and newly available free time, thanks to the work from home trend, to remodel their homes. Now that other retailers are opening their doors, the allure of being outright bullish the S&P HIR index has diminished (bottom panel). Add to this the fact that a great deal of future demand was pulled forward for HIR stores, and there is likely little upside left in the S&P HIR index. In addition, rates are moving higher at the margin, and energy costs are also breaking out. Taken together they form our consumer drag indicator and the implication is that the path of least resistance is lower for relative profit growth estimates (middle panel).  While the sector faces some headwinds, we remain neutral this consumer discretionary sub-industry and are not ready just yet to downgrade exposure. One offsetting factor is soaring lumber prices that are buttressing profits given that HIR make a set margin on lumber-related sales (not shown). Bottom Line: Stay neutral the S&P home improvement retail index, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. ​​​​​​​

Highlights The reason to own stocks is not profit growth. The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will be lacklustre, at best. The reason to own stocks is that the ultimate low in the T-bond yield is yet to come. This ultimate low in the T-bond yield will define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks… …and tilt towards long-duration growth sectors and growth-heavy stock markets such as the S&P500 that will benefit most from the final collapse in yields. The correction in DRAM, corn, and lumber prices suggests that the recent mania in inflation expectations is about to end. Fractal trade shortlist: copper and tin are fragile, go long T-bonds versus TIPS. Feature Chart of the WeekGlobal Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since Global Profits Surged During The Credit Boom, But Have Gone Nowhere Since The main reason to own stocks is not what you think. The usual long-term argument to own stocks is based on profit growth – specifically, that an uptrend in profits drives up stock prices. Except that since 2008, this is not true (Chart of the Week and Chart I-2). Profits have barely grown, yet the global stock market has doubled.1 Chart I-2Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown Since The Credit Boom Ended, Global Profits Have Barely Grown As profits have barely grown since 2008, the main reason that the global stock market has doubled is that the valuation paid for those profits has surged. Looking ahead, we expect this to remain the main reason to own stocks. The Reason To Own Stocks Is Not Profit Growth Profits are the product of sales and the profit margin on those sales. During the credit boom of the nineties and noughties, the strong tailwind of credit creation supercharged sales growth. At the same time, the profit margin on those sales trended higher (Chart I-3). Chart I-3Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Since The Credit Boom Ended, Sales Growth Has Slowed And Profit Margins Have Trended Lower Hence, in the decade leading up to 2008, global stock market profits surged, outstripping both sales and world GDP. Then the credit boom ended, and profits languished, because: Absent the tailwind from the credit boom, sales growth moderated. The profit margin trended lower. In the post-pandemic years, we expect both trends to persist. The credit boom is not coming back. Furthermore, as the pandemic recession was not protracted, sales are not at a depressed level from which they can play a sharp catch-up, as they did after the 2008 recession and the 2015 emerging markets recession. The structural downtrend in the profit margin will continue. Meanwhile, the structural downtrend in the profit margin will continue. Governments are desperate to mitigate – or at least, contain – the ballooning deficits that have paid for their pandemic stimuluses. Raising corporate taxes from structurally depressed levels is an easy and politically expedient response, as we have already seen from both the Biden administration in the US, and the Johnson administration in the UK. Higher corporate taxes will weigh on structural profit margins (Chart I-4). Chart I-4Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels Corporate Taxes Will Rise From Structurally Depressed Levels The combination of unspectacular sales growth and down-trending profit margins means that global profit growth will continue to be lacklustre, at best. The Reason To Own Stocks Is That The Ultimate High In Valuations Is Yet To Come To repeat, the main reason that the global stock market has doubled since 2008 is that its valuation has surged (Chart I-5). Chart I-5The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion The Main Driver Of The Stock Market Has Been Valuation Expansion In turn, the stock market’s valuation has surged because bond yields have plummeted. Empirically, the valuation of the global stock market is tightly connected with the simple average of the (inverted) yields on the safest sovereign bond, the US T-bond, and the riskier sovereign bond, the Italian BTP. The main reason that the global stock market has doubled since 2008 is that its valuation has surged. Through 2012-13, the decline in the Italian BTP yield, by signifying the fading of euro break-up risk, boosted stock valuations. In more recent years though, it has been the US T-bond yield that has been more influential in driving the global stock market’s valuation (Chart I-6). Chart I-6The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields The Stock Market's Valuation Expansion Is Due To Lower Bond Yields But the crucial point to grasp is that the relationship between the declining bond yield and stock market valuation becomes exponential. This is because as bond yields approach their lower bound, bond prices have less additional upside but considerably more downside. This extra riskiness of bonds means that investors demand a diminishing risk premium on equities versus bonds. So, as bond yields decline, the required return on equities – which equals the bond yield plus the risk premium – collapses. And as valuation is just the inverse of required return, valuations soar. Chart I-7 and Chart I-8 demonstrate this exponential relationship in practice. Note that the bond yield is on the logarithmic left scale while the stock market’s valuation is on the linear right scale. The logarithmic versus linear scale visually demonstrates that at a lower bond yield, a given change in the bond yield has a much greater impact on the stock market’s valuation. Chart I-7The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential The Relationship Between Lower Bond Yields And Stock Market Valuation Expansion Is Exponential Chart I-8When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge When Bond Yields Reach Their Ultimate Low, Stock Market Valuations Will Surge Specifically, if the 30-year yield in the US reached the recent low achieved in the UK, it would boost the stock market’s valuation by nearly 50 percent. We fully expect this to happen at some point in the coming years because of The Shock Theory Of Bond Yields which we introduced in last week’s report. In a nutshell, the shock theory of bond yields states that each successive deflationary shock takes the bond yield to a lower structural level, until it can go no lower. Although it is impossible to predict the timing and nature of individual shocks such as the pandemic, it is easy to predict the statistical distribution of shocks. On this basis, the likelihood of a net deflationary shock is 50 percent within the next three years, and 81 percent within the next five years. Whatever that deflationary shock is, and whenever it arrives, it will mark the ultimate low in the 30-year T-bond yield – at a level close to the recent low in the UK. This ultimate low in the T-bond yield will also define the ultimate high in the global stock market’s valuation and the end of the structural bull market in stocks. Until that ultimate low in bond yields, long-term investors should own stocks. And tilt towards long-duration growth sectors that will benefit most from the final collapse in yields. Growth sectors and growth-heavy stock markets such as the S&P500 will continue to outperform, as they have done consistently since 2008. The Inflation Bubble Is Bursting   The last couple of months has seen a mania in inflation expectations. As industries reconfigured for the end of lockdowns, supply bottlenecks in some commodities led to understandable spikes in their prices. These commodity price increases then unleashed fears about inflation. As investors sought inflation hedges, it drove up commodity prices more broadly … which added to the inflation fears…which added further fuel to the mania in inflation expectations. And so, the indiscriminate rally in commodities continued. The inflation bubble is bursting. But now it seems that the indiscriminate rally is over. DRAM prices have rolled over, belying the thesis that there is widespread shortage in semiconductors (Chart I-9). More spectacularly in the past week, the corn price has tumbled by 12 percent while the lumber price has slumped by 25 percent (Chart I-10). Chart I-9DRAM Prices Have ##br##Rolled Over DRAM Prices Have Rolled Over DRAM Prices Have Rolled Over Chart I-10Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Lumber Prices Are Correcting, Will Other Commodities Follow? Given that the commodity rally was indiscriminate, there is a danger that any correction will spread into other commodities like the industrial metals, copper and tin – especially as their fractal structures are at a level of fragility that has identified previous turning points in 2008, 2011, 2015, 2017 and 2020 (Chart I-11 and Chart I-12). Chart I-11Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Copper's Fractal Structure Is Fragile Chart I-12Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile Tin's Fractal Structure Is Fragile In any case, the mania in inflation expectations is about to end. An excellent way to play this is to expect compression in the market implied inflation rate in T-bond yields versus TIPS yields (Chart I-13). Chart I-13The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End The Mania In Inflation Expectations Is About To End Hence, this week’s recommended trade is to go long the 10-year T-bond versus the 10-year TIPS, setting a profit target and symmetrical stop-loss at 3.6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  To clarify, Chart 2 shows world stock market earnings per share, both 12-month forward and 12-month trailing. Whereas Charts 1 and 3 show sales and net profits (not per share). Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

On Shaky Ground On Shaky Ground Underweight High-Conviction While our underweight homebuilders call has been offside of late, we are sticking with it given the recent turn in some crucial data series. Interest and mortgage rates are a key determinant for the industry’s relative performance, and given the sell-off in the bond market, it is only a question of when, not if, US building permits will play catch up to the downside (mortgage rates shown inverted, middle panel). If rising mortgage rates (although from a low base) is not enough to cool down the US housing market, then an astronomical rise in lumber prices will likely weigh on it soon. As a reminder, framing lumber accounts for 15-20% of the total cost of building a home (bottom panel). Before long, this input cost inflation will eat into homebuilders’ margins and thus cut into profits. Bottom Line: We reiterate our cyclical and high-conviction underweight stance in the S&P homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR.  

Chart 1Chart 1 Chart 1 Chart 1 Not only did the pandemic claim millions of human lives and cause irreparable suffering, but it also permanently damaged a number of macro series and indicators, some of which we highlight in today’s Sector Insight report. Easy monetary and fiscal policies especially given the proverbial helicopter drop (stimulus checks) made nearly every consumer series unusable be it unit labor costs, average hourly earnings, unemployment insurance claims, etc. Chart 1 highlights that retail sales, the savings rate, and select inflation data are also rendered useless. As it is widely quoted in the media, the rise in fiscal spending was World War II-like, but M1 money supply plotted on a year-over-year growth rate basis dwarfs government largess (Chart 2). With all that money having to flow somewhere, select commodities are going through five standard deviation moves relative to their 50-year mean! Nevertheless, WTI crude oil trumps all else: it managed the unthinkable and traded down to roughly negative $40/bbl, before rebounding to the current $65/bbl level (Chart 3). Finally, BCA’s boom/bust indicator is just that, bust as the COVID-19 recession wreaked havoc to a previously dependable indicator which gauged different stages of the business cycle (Chart 3). Bottom Line:  Further mean reversion looms in economic data across the board including a 4-6% fiscal cliff that will likely come in 2022 (as we highlighted in yesterday’s Webcast) making us wary about the near-term prospects of the US equity market that has likely priced in all the good news. Chart 2Chart 2 Chart 2 Chart 2 Chart 3Chart 3 Chart 3 Chart 3 ​​​​​​​

Highlights The ECB is not repressing interest rates and penalizing savers. The Eurozone shows none of the symptoms associated with financial repression. Global excess savings are keeping US rates depressed. If US rates are low, then European rates must be lower because of structural problems in the region’s economy, independent of the ECB’s preferences. Structurally, there is still no case for European yields to rise meaningfully compared to the rest of the world. Despite positive forces over the next year or two, European financials will remain long-term underperformers. European utilities will outperform US ones. The euro is transforming into a safe haven like the yen and the Swiss franc. Feature By maintaining negative short rates, the European Central Bank is conducting severe financial repression, which distorts rates of return and penalizes savers. This is a common refrain among many insurers and pension plan managers investing in Europe and among a large number of the region’s politicians. Chart 1The ECB's Financial Repression? The ECB's Financial Repression? The ECB's Financial Repression? At first glance, this criticism is apt. For the past five years, negative policy rates have forced safe-haven Bund yields to trade well below the Euro Area’s nominal GDP growth (Chart 1). Moreover, the real ECB deposit rate remains well below the Holston, Laubach-Williams estimate of R-star (the real neutral rate of interest). If we go beyond these superficial observations, it is far from clear that the ECB is conducting financial repression or distorting market rates any more than other major global central banks. Is It Financial Repression? The ECB is not conducting financial repression; rather, it is responding to powerful economic forces in Europe and beyond that are depressing interest rates. The definition of financial repression is crucial to this assessment. Financial repression involves monetary authorities actively suppressing interest rates to the advantage of the borrowers and users of capital at the expense of the savers, whose risk-free investments then provide subpar rates of returns. Following this definition, financial repression shows these clear symptoms: A low savings rate. Suppressed interest rates do not adequately compensate savers to forgo consumption. Thus, they are less likely to put money aside. A significant build-up of debt. Real interest rates are below fair market value, which subsidizes borrowing. A significant expansion of the money supply. Money supply expands rapidly in response to strong credit demand in the economy. Plentiful capital expenditures. Savers must take on more financial risk to make appropriate returns on their assets, which compresses risk premia. Depressed internal rates of return boost the net present value of investment projects and thus cause investments to account for a large share of output. A current account deficit. A nation’s current account balance equals its savings minus its investments. By depressing savings and stimulating investments, financial repression results in a current account deficit or a sharply deteriorating current account balance. Above-trend GDP growth. By depressing savings and boosting investments, financial repression lifts cyclical spending and forces the GDP to rise above its potential. The problem for commentators who argue that the ECB is conducting financial repression is that the Euro Area meets none of these criteria. First, Eurozone money and credit growth has run well below that of the US ever since the euro crisis, despite ECB policy rates that are constantly lower than the Fed Funds rate. Moreover, since the ECB cut rates to zero, the pace of money and credit creation has decelerated significantly compared to their pre-crisis trends (Chart 2). Second, the Euro Area’s real GDP per capita, nominal GDP per capita, and the GDP deflator have also fallen 4.6%, 5.2% and 5%, respectively, behind those of the US, since the ECB has cut interest rates to zero (Chart 3). Moreover, the growth of these variables has also decelerated significantly over this period, which is consistent with depressed credit demand. Additionally, despite the inferior performance of European activity metrics compared to those of the US since the introduction of the common currency, European government bonds have performed exactly in line with those of the US (Chart 3, bottom panel) and have therefore outperformed in real terms. This is inconsistent with financial repression by the ECB. Chart 2Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Europe's Money And Credit Trends Are Too Tame... Chart 3... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends ... So Are Output Volume And Price Trends Finally, the Euro Area runs a current account surplus of 2.3% of GDP, which has grown by 4.1% of GDP since late 2008. This is the clearest sign that Eurozone savings have become excessive relative to investment, despite the surge in government deficits in the wake of the COVID-19 pandemic. Excess savings are not typically associated with central banks artificially distorting interest rates. Bottom Line: The economic developments in the Euro Area do not correspond to what would be anticipated if the ECB were repressing interest rates. The growth rate of money and credit has structurally slowed both in absolute terms and compared to that of the US. The same deceleration is evident in both real and nominal output per person, as well as in price levels. Finally, the Eurozone’s current account surplus has widened, which highlights that savings have grown in excess of investments. The Eurozone Needs Lower Interest Rates Than The US The ECB must set appropriately low interest rates, if US yields are low across the curve. In a way, the case that the Federal Reserve is conducting financial repression is stronger than the case against the ECB. Over the past twelve years, nominal and real output per capita have grown more robustly in the US, while money as well as credit expansion and inflation have also been stronger. The US runs a persistent current account deficit of 3.1% of GDP, which also indicates that it is not awash in excess domestic savings. Chart 4Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates Maybe The Fed Is Repressing Interest Rates We could even argue that the case for the Fed repressing interest rates is growing stronger. The federal budget deficit has expanded to 19% of GDP, even as the unemployment rate tumbles (Chart 4). Moreover, US quarterly GDP growth has averaged 8.5% since the fourth quarter of 2020 and, according to Bloomberg consensus estimates, is anticipated to average 6.3% for the remainder of the year. US inflation is also strong. Annual core CPI Inflation hit 3% in April; monthly core inflation was 0.92%, or an annualized rate of 11.6%, the strongest reading in almost 40 years. Yet, even in the US, the argument that the Fed is repressing interest rates is ultimately weak, despite the aforementioned economic strength. The Fed is accommodating global market pressures that are greater than those of the US economy. In other words, even if the Fed did not set short rates, US interest rates would be low across the curve because of global excess savings. Chart 5Too Much Savings, Everywhere Too Much Savings, Everywhere Too Much Savings, Everywhere Excess savings around the world constitute an exceptionally strong gravitational force that anchor global rates at low levels. As Chart 5 shows, since the early 1990s, global private savings have outpaced investments by a cumulative 163% of GDP. Accumulated government deficit, which has accounted for 99% of global GDP, has been far too small to absorb fully this surplus of savings. The resulting imbalance places downward pressure on global inflation (a consequence of demand falling short of supply) and real interest rates, which means it depresses nominal interest rates across the curve. US interest rates also feel the yield-compressing effect of these excess global savings, even if the US economy does not generate excess savings itself (it runs a current account deficit). The major DM central banks are removing a greater proportion of the float of safe-haven from their jurisdictions than the Fed (Chart 6). The resulting scarcity of safe-haven securities means that US fixed-income products remain the natural outlet for global investors seeking safety and liquidity. Thus, despite the US lack of excess savings, Treasury yields have traded below nominal GDP growth 55% of the time over the past 30 years, no matter how strong US activity is or how wide federal deficits become. If the Fed has little choice but to accept low US interest rates, then the Eurozone must accept even lower interest rates because of its large excess savings. As Chart 7 illustrates, the 2-year and 10-year interest rate spreads (both in nominal and real terms) between the Eurozone and the US track the gap between the US current account deficit and the Europe’s current account surplus. Chart 6Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Treasurys Are The World Only Plentiful Safe-Haven Chart 7Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve Europe's Excess Savings Justify Lower Rates Across The Curve The Eurozone lower rate of return on capital is another force depressing rates relative to the US (Chart 8). This lower return on capital reflects the following structural problems with the European economies: Excess capital stock. The Eurozone peripheral nations have abnormally large capital stocks in relation to their GDPs (Chart 9). As we previously argued, this feature means that Europe suffers from large amounts of misallocated capital, which hurt the return on capital. Chart 8Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Capital Is Not Rewarded In Europe Chart 9Too Much Capital! Too Much Capital! Too Much Capital! Ageing capital stock. Not only is the Eurozone capital stock too large relative to the size of its economy, it is also older than that of the US (Chart 10). An ageing capital stock, especially in a world where ICT spending is one of the key sources of innovation and growth, further hurts the Euro Area’s return on capital. Lower incremental output-to-capital ratio (Chart 11). The Euro Area generates significantly less output per unit of investment than the US. This confirms the notion that capital is misallocated and that it is used less productively than in the US. Chart 10Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Europe's Capital Is Ageing Too Chart 11Poor Capital Utilization Poor Capital Utilization Poor Capital Utilization Chart 12Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem Europe's Inferior Productivity Problem The final force limiting European interest rates compared to the US is the Euro Area’s inferior potential growth rate. The Eurozone’s population is ageing, and it will start to contract in 2030. Moreover, multifactor productivity growth is weaker than in the US (Chart 12). A lower potential GDP growth accentuates the discount in the Euro Area neutral rate of interest compared to the US. Bottom Line: Despite the relative economic vigor of the US, global excess savings lower US rates across the curve. The ECB has no choice but to accept even lower European rates, because the European economy suffers from greater excess savings than the US: its return on capital is inferior, and its neutral rate of interest is hampered by its lower potential GDP growth. Investment Conclusions For European rates to avoid the fate of Japan and to circumvent suffering many more decades wedged near zero, some important changes must take place. First, at the global level, excess savings must recede. This will allow global interest rates to increase, especially those of the US. Even if Eurozone rates continue to trade at a discount to the US, safe-haven yields in Europe would nonetheless climb in absolute terms. The fall in the global ratio of workers relative to dependent people, most notably in China where the 2020 population census has just highlighted the trend, is one factor pointing toward a potential gradual decline in global savings. For the moment, absorbing excess savings means that global fiscal policy must remain accommodative. Although fiscal authorities around the world continue to display greater profligacy than they did in the wake of the Great Financial Crisis, there is no guarantee that they will not revert to their old ways. In fact, BCA’s Global Investment Strategy service recently showed that the US fiscal policy is set to become more of a constraint on growth next year than it has been in 2020 and 2021 (Chart 13).  One factor to monitor is the international shift in voters’ preferences toward left-wing economic policies, which often results in more generous fiscal spending. If this trend persists, then global fiscal deficits will close more slowly than the private sector savings will decline. This process will both be inflationary over the long run and impose upward pressure on real interest rates worldwide. But the fiscal excesses of the current moment may force opposition parties to restrain spending whenever they come into power. Chart 13Will Global Fiscal Policy Morph Into a Headwind? The ECB Is Not In Charge The ECB Is Not In Charge Second, to narrow the spread between the Eurozone and US interest rates, the Euro Area must tackle its low rate of return on capital. Practically, this means that much of the excess capital stock weighing on European rates of returns must be written down. Doing so will require more cross border mergers and acquisitions within sectors in the Eurozone. However, the loss-recognition process on nonviable capital will be deflationary. Thus, to facilitate these asset write-downs, the region’s fiscal policy and monetary policy must first remain extremely accommodative. It is far from certain that European authorities will resist reverting to their old ways. A structural underweight on European financial equities remains appropriate. Even if the Eurozone enacts the reforms necessary to invite the peripheral asset write-downs required to boost rates of return in the long-run, in the interim, these reforms will be deflationary. Consequently, no matter what, Eurozone yields will remain well below the US for years to come. Moreover, European credit demand is unlikely to outperform the rest of the world for the coming few years. In this context, the RoE of European banks will remain low. Therefore, our current recommendation to overweight this sector is only valid as a near-term play on the global economic recovery and is not a strategic recommendation. By contrast, European utilities will structurally outperform their US counterparts. European utilities offer higher RoE than US ones and have healthier leverage (Chart 14). Moreover, European utilities trade at discounts to US firms on a price-to-book, price-to-cash flow, price-to-sales and dividend yield basis (Chart 15). Additionally, as yield plays, structurally lower European yields relative to those of the US will advantage European utilities on a long-term basis. Chart 14European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... European Utilities Offer More Appealing Operating Metrics... Chart 15... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones ... And Are More Attractively Priced Than US Ones Finally, the euro will increasingly trade as a safe-haven currency like the yen and the Swiss franc. First, after a decade of trial by fire, EU integration and solidarity have gained rather than lost momentum and the EU break-up risk has proved to be limited to Brexit. Second, although the Eurozone economy is pro-cyclical, so are the Swiss and Japanese economies. Instead, the Euro Area’s structurally elevated savings rate and current account balance are transforming this economy into a net creditor, with a positive net international investment position equal to -0.1% of GDP. Moreover, the bloc’s low inflation will continue to put upward pressure on the euro’s long-term fair value. If we add the Euro Area’s low interest rates to the mix, then the euro is likely to behave increasingly as a funding currency. Thus, while the euro will benefit from the USD’s weakness forecasted by our Foreign Exchange Strategists, it will underperformed more pro-cyclical currencies such as the SEK, the NOK, or the GBP, which do not suffer from the same ills as the Eurozone.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

Chart 1 Chart 1 Chart 1 In late April, we revisited our Infrastructure Basket in light of President Biden pumping out one fiscal package after another. BCA’s view also remains that the populist shift in US politics is just getting started and that likely more fiscal packages, in one form or another, are coming in the future. This brings us to the question of how much is already priced in, and is it too late to jump on the fiscal train? While the bottom panel of Chart 1 is showing that our Infrastructure Basket is getting expensive on the 12-month forward P/S ratio, we do note that there is little historical data to go by and only two business cycles. On the other hand, the middle panel of Chart 1 demonstrates that the Infrastructure Basket is fairly valued when looking at the forward P/E ratio: it is currently hovering just a few pixels away both from the zero-line and the historical mean making our basket an attractive addition to investors' equity portfolios. Bottom Line: We reiterate our cyclical and structural USES Infrastructure basket overweight recommendations. For completion purposes, Charts 2-5 below also breakdown our basket into its GICS4-level constituents.   Chart 2 Chart 2 Chart 2 Chart 3 Chart 3 Chart 3   Chart 4 Chart 4 Chart 4 Chart 5 Chart 5 Chart 5        

Highlights Global stocks are very vulnerable to a correction. But cyclically the Fed is committed to an inflation overshoot and the global economy is recovering. China’s fiscal-and-credit impulse fell sharply, which leaves global cyclical stocks and commodities exposed to a pullback. Beyond the near term, China’s need for political stability should prevent excessive policy tightening. The risk is frontloaded. China’s population census underscores one of our mega-themes: China’s domestic politics are unstable and can bring negative surprises. India’s state elections, held amid a massive COVID-19 wave, suggest that the ruling party is still favored in 2024. This implies policy continuity. Stick with a bullish cyclical bias but be prepared to shift if China commits a policy mistake. Feature Chart 1Inflation Rears Its Head Inflation Rears Its Head Inflation Rears Its Head Global markets shuddered this week in the face of a strong core inflation print in the US as well as broader fears as inflation rears its head after a long slumber (Chart 1). Cyclically we still expect investors to rotate away from US stocks into international stocks and for the US dollar to fall as the global economy recovers (Chart 2). However, this view also entails that emerging market stocks should start outperforming their developed market peers, which has not panned out so far this year. Emerging markets are not only technology-heavy and vulnerable to rising US bond yields but also further challenged now by China’s stimulus having peaked. Chart 2Equity Market Trembles Equity Market Trembles Equity Market Trembles Chart 3Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Global Economy And Sentiment Recovering Chart 4Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering Global Cyclicals Versus Defensives Wavering The one thing we can rely on is that the COVID-19 vaccine rollout will continue to enable a global growth recovery (Chart 3). The US dollar is signaling as much. The greenback bounced in the first quarter on US relative growth outperformance but it has since fallen back. A falling dollar is positive for cyclical stocks relative to defensives, although cyclicals are flagging that the reflation trade is overdone in the near term (Chart 4). China’s growth now becomes the critical focal point. A policy mistake in China would upset the bullish cyclical view. China’s tightening of monetary and fiscal policy is a major global policy risk that we have highlighted this year and it is now materializing. However, we have also highlighted the constraints to tightening. At present China is standing right on the threshold of overtightening according to our benchmarks. If China tightens further, we will take a fundamentally more defensive view. Also in this report we will review the results of China’s population census and the implications of India’s recent state elections in the face of the latest big wave of COVID-19 infections. We are not making any changes to our bullish view on India yet but we are putting it on watch. China: The Overtightening Risk China’s troubles stem from the ongoing change of its economic model from reliance on foreign trade to reliance on domestic demand. This was a strategic decision that the Communist Party made prior to the rise of President Xi Jinping. Xi also has come to embody it and reinforce it through his strategic vision and confrontation with the United States. Beijing’s goal was to manage a smooth and stable transition. The financial turmoil of 2015 and the trade war of 2018-19 jeopardized that goal but policymakers ultimately prevailed. Then COVID-19 broke out and caused the first real economic contraction since the 1970s. While China contained the virus and bounced back with another massive round of stimulus (13.8% of GDP from the onset of the trade war to the 2021 peak), it now faces an even more difficult transition. Chart 5China's Rising Propensity To Save China's Rising Propensity To Save China's Rising Propensity To Save The need to improve quality of life is more urgent given that potential GDP has slowed. The need to contain systemic financial risk is more urgent given the big new increase in debt. And the need to diversify the economy is more urgent given that the US is now creating a coalition of democracies to confront China over a range of policies. The spike in the “marginal propensity to save” among Chinese people and corporations – as measured by the ratio of long-term cash deposits to short-term deposits – is an indication that the country is beset by troubles and animal spirits are depressed (Chart 5). China’s fiscal-and-credit impulse is turning down after the large expansion in 2018-21. Policymakers have signaled since last year that they would withdraw emergency stimulus and now the impact is apparent in the hard data. China’s money, credit, and combined credit-and-fiscal impulses all correlate with economic growth after a six-to-nine-month lag. This is true regardless of which indicators one uses for China’s money and credit cycles and economic activity (Charts 6A and 6B). China’s economic momentum is peaking and will become a headwind for the global economy later this year and in 2022, even though the world is otherwise enjoying the tailwinds of vaccination and economic reopening. Chart 6AChina’s Fiscal-And-Credit Impulse Falls Sharply … China's Fiscal-And-Credit Impulse Falls Sharply... China's Fiscal-And-Credit Impulse Falls Sharply... Chart 6B… As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses ... As Do Money-And-Credit Impulses The downshift in the fiscal-and-credit impulse portends a slowdown in demand for commodities, materials, and other goods that China imports, especially for domestic consumption. (Chinese imports of parts and inputs that go into its manufacturing exports to the rest of the world look healthier as the rest of the world recovers.) This shift will make it hard for high-flying metals prices and other China plays, such as Swedish stocks, to continue rising without a correction (Chart 7). Speculative positioning is heavily in favor of commodities at the moment. The divergence between China and the metals markets that it dominates looks untenable in the short run (Chart 8). Chart 7China Reflation Trades Near Peaks China Reflation Trades Near Peaks China Reflation Trades Near Peaks Chart 8Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash Money Cycle And Commodity Prices Clash The global shift to green or renewable energy systems (i.e. de-carbonization) is bullish for metals, especially copper, but will not be able to make up for the fall in Chinese demand in the short run, as our Emerging Markets Strategy has shown. China’s domestic uses of copper for construction and industry make up about 56.5% of global copper demand while the green energy race – namely the production of solar panels, windmills, electric cars – makes up only about 3.5% of global demand. This number somewhat understates the green program since re-gearing and retrofitting existing systems and structures is also projected, such as with electricity grids. But the point is that a drop in China’s copper consumption will work against the big increase in American and European consumption – especially given that the US infrastructure program will not kick in until 2022 at the earliest. Hence global copper demand will slow over the next 12 months in response to China even though the rest of the world’s demand is rising. Chinese policymakers have not yet signaled that they are worried about overtightening policy or that they will ease policy anew. The Politburo meeting at the end of April did not contain a major policy change from the Central Economic Work Conference in December or the Government Work Report in March (Table 1). But if there was a significant difference, it lay in reducing last year’s sense of emergency further while projecting some kind of scheme to hold local government officials accountable for hidden debt. The implication is continued tight policy – and hence the risk of overtightening remains substantial. Table 1China’s Recent Macroeconomic Policy Statements: Removing Stimulus China Verges On Overtightening China Verges On Overtightening Chart 9Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening Benchmarks For China's Policy Tightening True, the tea leaves of the April meeting can be read in various ways. The April statement left out phrases about “maintaining necessary policy support” from the overarching macroeconomic policy guidance, which would imply less support for the economy. But it also left out the goal of keeping money supply (M2) and credit growth (total social financing) in line with nominal GDP growth, which could be seen as enabling a new uptick in credit growth. However, the People’s Bank of China did maintain this credit goal in its first quarter monetary policy report, so one cannot be sure. Notice that according to this rubric, China is right on the threshold of “overtightening” policy that we have utilized to measure the risk (Chart 9). Based on Chinese policymaking over the past two decades, we would expect any major inflection point to be announced at the July Politburo meeting, not the April one. We do not consider April a major change from the preceding meetings – nor does our China Investment Strategy. Therefore excessive policy tightening remains a genuine risk for the Chinese and global economy over the next 12 months. Our checklist for excessive tightening underscores this point (Table 2). Table 2Checklist For Chinese Policy Tightening China Verges On Overtightening China Verges On Overtightening China’s fiscal-and-credit downshift is occurring in advance of the twentieth national party congress, which will take place throughout 2022 and culminate with the rotation of the top leadership (the Politburo Standing Committee) in the autumn. The economy is sufficiently stimulated for the Communist Party’s hundredth birthday on July 1 of this year, so policymakers are focused on preventing excesses. Financial risk prevention, anti-monopoly regulation, and tamping down on the property bubble are the orders of the day. The increase in corporate and government bond defaults and bankruptcies underscore the leadership’s willingness to push forward with economic restructuring and reform, which is well-attested in recent years (Chart 10). Chart 10Creative Destruction In China China Verges On Overtightening China Verges On Overtightening Investors cannot assume that the party congress in 2022 is a reason for the leadership to ease policy. The contrary occurred in the lead-up to the 2017 party congress. However, investors also cannot assume that China will overtighten and sink its own economy ahead of such an important event. Stability will be the goal – as was the case in 2017 and previous party congresses – and this means that policy easing will occur at some point if the current round of tightening becomes too painful financially and economically. China-linked assets are vulnerable in the short run until policymakers reach their inflection point. Incidentally, the approach of the twentieth national party congress will be a magnet for political intrigue and shocking events. The top leader normally sacks a prominent rival ahead of a party congress as a show of force in the process of promoting his faction. The government also tightens media controls and cracks down on dissidents, who may speak up or protest around the event. But in 2022 the stakes are higher. President Xi was originally expected to step down in 2022 but now he will not, which will arouse at least some opposition. Moreover, under Xi, China has undertaken three historic policy revolutions: it is adopting a strongman leadership model, to the detriment of the collective leadership model under the two previous presidents; it is emphasizing economic self-sufficiency, at the expense of liberalization and openness; and it is emphasizing great power status, at the expense of cooperation with the United States and its allies. Bottom Line: Global equities, commodities, and “China plays” stand at risk of a substantial correction as a result of China’s policy tightening. Our base case is that China will avoid overtightening but the latest money and credit numbers run up against our threshold for changing that view. Another sharp drop in these indicators will necessitate a change. China’s Disappearing Workforce Ultimately one of the constraints on overtightening policy is the decline in China’s potential GDP growth as a result of its shrinking working-age population. China’s seventh population census came out this week and underscored the deep structural changes affecting the country and its economy. Population growth over the past ten years slowed to 5.4%, the lowest rate since the first census in 1953. The fertility rate fell to 1.3 in 2020, lower than the 2.1 replacement rate and the 1.8 target set when Chinese authorities relaxed the one-child policy in 2016. The fertility rate is also lower than the World Bank’s estimates (1.7 in 2019) and even Japan’s rate. The birthrate (births per 1,000 people) also fell, with the number of newborns in 2020 at the lowest point since 1961, the year of the Great Famine. The birth rate has converged to that of high-income countries, implying that economic development is having the same effect of discouraging childbearing in China, although China is less developed than these countries. Chart 11China’s Working Population Falling Faster Than Japan’s In 1990s China Verges On Overtightening China Verges On Overtightening The youngest cohort rose from 16.6% to 17.95% of the population, the oldest cohort rose 8.9% in 2010 to 13.5% today, while the working-age cohort fell from 75.3% to 68.6%. The working-age population peaked in 2010 and fell by 6.79 percentage points over the past ten years. By contrast, Japan’s working-age population peaked in 1992 and fell 2.18 percentage points in the subsequent decade (Chart 11). In other words China is experiencing the demographic transition that hit Japan in the early 1990s – but China’s working-age population might fall even faster. The country is experiencing this tectonic socioeconomic shift at a lower level of per capita wealth than Japan had attained. The demographic challenge will put pressure on China’s socioeconomic and political system. The China miracle, like other Asian miracles, was premised on the use of export-manufacturing to generate large piles of savings that could be repurposed for national development. The decline in China’s working-age population coincides with economic development and a likely decline in the saving rate over the long run. This is shown in Chart 12, which shows two different pictures of China’s working population alongside the gross national saving rate. As China’s dependency ratio rises the saving rate will fall and fewer funds will be available for repurposing. The cost of capital will rise and economic restructuring will accelerate. In the case of Japan, the demographic shift coincided with the 1990 financial crisis and then a nationwide shift in economic behavior. The saving rate fell as the economy evolved but the savings that were generated still exceeded investment due to the shortfall in private demand and the pressure of large debt burdens. Companies focused on paying down debt rather than expanding investment and production (Chart 13). All of this occurred when the external environment was benign, whereas China faces a similar demographic challenge in the context of rising economic pressure due to geopolitical tensions. Chart 12Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chinese Workers Getting Scarcer Chart 13High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms High Savings Enable Debt Splurge Until Debt Overwhelms China has so far avoided a debilitating financial crisis and collapse in real estate prices that would saddle the country with a traumatizing liquidity trap. The Chinese authorities are painfully aware of the danger of the property bubble and are therefore eager to prevent financial excesses and curb bubble-like activity. This is what makes the risk of overtightening significant. But a mistake in either direction can lead to a slide into deflation. The Xi administration has stimulated the economy whenever activity slowed too much or financial instability threatened to get out of hand, as noted above, but this is a difficult balancing act, which is why we monitor the risk of excessive tightening so closely. A few other notable takeaways from China’s population census include: The two-child policy is not succeeding so far. COVID-19 might have had a negative effect on fertility but it could not have affected births very much due to the timing. So the trends cannot be distorted too much by the pandemic. Rapid urbanization continues, with the rate hitting 64% of the population, up 14 percentage points from 2010. Policy discussions are emphasizing lifting the retirement age; providing financial incentives for having babies; a range of price controls to make it more affordable to have babies, most notably by suppressing the property bubble; and measures to ensure that property prices do not fall too rapidly in smaller cities as migration from the country continues. China’s ethnic minority population, which consists of 9% of the total population, grew much faster (10% rate) over the past decade than the Han majority, which makes up 91% of the population (growing at a 5% rate). Minorities are exempt from the one-child (and two-child) policy. Yet ethnic tensions have arisen, particularly in autonomous regions like Xinjiang, prompting greater international scrutiny of China’s policies toward minorities. China’s demographic challenge is widely known but the latest census reinforces the magnitude of the challenge. China’s potential growth is falling while the rising dependency ratio underscores social changes that will make greater demands of government. Greater fiscal and social spending needs will require difficult economic tradeoffs and unpopular political decisions. Economic change and the movement of people will also deepen regional and wealth disparities. All of these points underscore one of our consistent Geopolitical Strategy mega-themes: China’s domestic political risks are underrated. Bottom Line: China’s 2020 census reinforces the demographic decline that lies at the root of China’s rising socioeconomic and political challenges. While China has a strong central government with power consolidated under a single ruling party, and a track record of managing its various challenges successfully in recent decades, nevertheless the magnitude of the changes happening are overwhelming and will bring negative economic and political surprises. India: State Elections Not A Turning Point Against Modi At the height of the second COVID-19 wave in India, elections were held in five Indian states. Results for the state of West Bengal were most important. West Bengal is a large state, accounting for nearly a-tenth of legislators at India’s national assembly, and the ruling Bharatiya Janata Party (BJP) of Prime Minister Narendra Modi had declared that it would win nearly 70% of the 294 seats there. In the event West Bengal delivered a landslide victory for the All India Trinamool Congress (AITMC), a regional party. Despite the fact that the AITMC was facing a two term anti-incumbency, the AITMC seat count hit an all-time high. Few had seen this coming as evinced by the fact that AITMC’s performance exceeded forecasts made by most pollsters. What should investors make of the BJP’s loss in this key state? Was it a backlash against Modi’s handling of the pandemic? Does it portend a change of government and national policy in the general elections in 2024? Not really. Here we highlight three key takeaways: Takeaway #1: The BJP’s performance was noteworthy Chart 14India: BJP Gets Foot In Door In West Bengal China Verges On Overtightening China Verges On Overtightening Whilst the BJP fell short of its goals in West Bengal, the state is not a BJP stronghold. The BJP is known to have natural traction in Hindi-speaking regions of India and West Bengal is a non-Hindi speaking state where the BJP was traditionally seen as an outsider. Also, this state is known to be unusually unwilling to accept change. For instance, before AITMC, the Left was in power for a record spell of 34 years in this state. In such a setting, the BJP’s performance in 2021 in West Bengal is noteworthy: the party increased its seat count to 77 seats, compared to only 3 seats in 2016 (Chart 14). This performance now catapults the BJP into becoming the key opposition party in West Bengal. It also indicates that the BJP may take time but has what it takes to build traction in states that are not traditional strongholds. Given that it achieved this feat in a state where it has little historic strength, its performance is noteworthy as a sign that the BJP remains a force to be reckoned with. Takeaway #2: The BJP’s popularity slipped but it is still favored to retain power in 2024 Whilst discontent against the BJP is rising on account of its poor handling of COVID-19 and the accompanying economic distress, there remains no viable alternative to the BJP at the national level. The recent state elections, not only in West Bengal, confirm that the opposition Indian National Congress (INC) is yet to get its act in order. The Congress party collapsed from 44 seats in Bengal to 0 seats. More importantly, the Congress is yet to resolve two critical issues, i.e. the need to appoint or elect an internal leader with mass appeal, and the need to develop an identifiable policy agenda. The weakness of the Congress means that while the BJP’s seat count could diminish as against its 2019 peak performance, nevertheless our base-case scenario for 2024 remains that of a BJP-led government maintaining power in India. Policy continuity and the chance of some structural reform are still the base case. Takeaway #3: The rise and rise of India’s regional parties The rise of the BJP over the last decade has coincided with losses in seats by both the Congress party and India’s regional parties. However, the most recent round of state elections signals that the BJP cannot compress regional parties’ seat share drastically. For instance, in West Bengal, it managed to win 77 seats by itself but this was not at the expense of the AITMC, which is the dominant player in this state. In another large state where elections were held earlier this month, i.e. Tamil Nadu, control continues to fluctuate between two well-entrenched regional parties. Chart 15India: BJP Peaked In 2019 But Still Favored 2024 China Verges On Overtightening China Verges On Overtightening The 2019 general elections saw the share of regional parties (defined as all parties excluding the BJP and Congress) fall to 35% from the near 40% levels seen at the general elections of 2014 (Chart 15). The 2024 elections could in fact see regional parties’ seat share move up a notch as the BJP’s peak seat count could diminish from the highs of 2019. The coming rise of India’s regional parties is a trend rooted in a simple dynamic. With the BJP as a two-term incumbent in the 2024 elections, voters could choose to gratify regional parties at the margin, in the absence of any alternative to the BJP at the national level. The BJP remains in a position to be the single largest party in India in 2024 with a seat count in excess of the half-way mark. But could a situation arise where the ruling party pulls in a regional party to stay ahead of the half-way mark with a large buffer? Absolutely. But of course 2024 is a long way away. Managing COVID-19 and its economic fallout will make it harder than otherwise for the BJP to beat its 2019 performance. The next bout of key state elections in India are due in February 2022 and India’s largest state, Uttar Pradesh, will see elections. With the BJP currently in power in this Hindi-speaking state, the February 2022 elections will shed more light on BJP’s ability to mitigate the anti-incumbency effect of the pandemic and economic shock. Bottom-Line: BJP’s popularity in India has been shaken but not dramatically so. The BJP remains firmly in a position to be the single largest party in India with a seat count that should cross the half-way mark in 2024. So government stability is not a concern in this emerging market for now. In light of China’s domestic political risks, and India’s political continuity, we will maintain our India trades for the time being (Charts 16A and 16B). However, we are undertaking a review of India as a whole and will update clients with our conclusions in a forthcoming special report. Chart 16AStay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Stay Long Indian Bonds Versus EM Chart 16BStick To Long India / Short China Stick To Long India / Short China Stick To Long India / Short China Investment Takeaways Maintain near-term safe-haven trades. Close long natural gas futures for a 19.8% gain. Maintain cyclical (12-month) bullish positioning with a preference for value over growth stocks. Maintain long positions in commodities, including rare earth metals, and emerging markets. But be prepared to cut these trades if China overtightens policy according to our benchmarks. For now, continue to overweight Indian local currency bonds relative to emerging market peers and Indian stocks relative to Chinese stocks. But we are reviewing our bullish stance on India. Chart 17Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Cyber Security Stocks Perk Up Amid Tech Rout Stay long cyber security stocks – though continue to prefer aerospace and defense over cyber security as a geopolitical “back to work” trade. Cyber security stocks perked up relative to the tech sector during the general tech selloff over the past week. The large-scale Colonial Pipeline ransomware cyber attack in the US temporarily shuttered a major network that supplies about 45% of the East Coast’s fuel (Chart 17). Nevertheless the attack on critical infrastructure highlights that cyber security is a secular theme and investors should maintain exposure. Cyber stocks have outperformed tech in general since the vaccine discovery (Chart 18). Chart 18Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Cyber Security Is A Secular Theme Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Ritika Mankar, CFA Editor/Strategist Ritika.Mankar@bcaresearch.com

Overweight Buy Biotech Stocks Against The Grain Buy Biotech Stocks Against The Grain In last week’s Strategy Report, we made a couple of changes within the health care universe; namely we upgraded pharma to neutral and boosted biotech stocks to overweight both of which lifted the S&P health care sector to an above benchmark allocation. This move serves as a hedge to our overall portfolio positioning. With regard to biotech equities, we posited that this highly fragmented industry is prime for consolidation. Even in the large cap S&P 500 biotech index there is scope for further M&A activity. Not only intra-industry mergers, but also cash rich and drug pipeline extension thirsty Big Pharma is lurking in the shadows ready to deploy their cash hoard. Already, there is an ongoing mini M&A boom and given the recent biotech firms’ success stories in the race to discover the COVID-19 vaccine, they command a high profile in investment banking board rooms (see chart). The implication is that as the M&A boom gains further traction, it effectively reduces the supply of stocks available to investors, consequently driving prices higher. Bottom Line: We reiterate our recent upgrade in the S&P biotech index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX– AMGN, ABBV, GILD, VRTX, REGN, ALXN, BIIB, INCY.​​​​​​​