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Highlights Our 80% odds that Biden will pass the $2.3 trillion American Jobs Plan stem from public opinion as well as Democratic control of Congress. Voters favor both higher taxes on corporations and higher infrastructure spending, as well as Biden’s proposal to pay for the latter by means of the former. A bipartisan consensus favors infrastructure spending, including “soft” infrastructure. Republicans who campaigned on the need for infrastructure over the past five years will not gain voter support by opposing it now. The Senate parliamentarian’s recent ruling on budget reconciliation procedures enables the Democrats to pass a second reconciliation bill, as expected. This puts Biden’s American Families Plan, to be detailed this month, officially into play for FY2022. Our initial premise remains a 50/50 chance that the $1.9 trillion bill passes before the 2022 midterms. Infrastructure plays benefit from a rising budget deficit but will also face a global headwind as China’s stimulus and growth momentum wane. Feature The market cheered the Biden administration’s $2.3 trillion American Jobs Plan despite the confirmation that corporate tax rates will go up as expected (Chart 1). The details of the plan are shown in Table 1, which makes it clear that $760 billion can easily be subtracted from the plan during negotiations as not having to do with infrastructure. However, investors should wager that most of the new spending, including the social welfare components, will pass, since Democrats will use the budget reconciliation process. Chart 1Market Response To Biden, Infrastructure, Tax Hikes Table 1Biden's 'American Jobs Plan' The bigger question is tax hikes. Senator Joe Manchin of West Virginia reiterated that a 25% corporate tax rate is as high as he is willing to go. Since Democrats cannot spare a single vote in the Senate (not to mention six or seven votes, which Manchin claims to have on his side), the corporate tax rates may be compromised. Still, investors should prepare for the worst, i.e. the 28% rate that Biden presented or only slightly less. While Manchin is the critical marginal voter – his vote will turn the balance of power in the Senate – nevertheless there will be enormous pressure on him not to “betray” his party and vote against the signature legislative proposal of the Biden presidency. Insofar as Manchin succeeds, he presents a “less bad” outcome for equity sectors that stand to suffer the most from a higher headline corporate tax rate, such as utilities, health care, and information technology (Chart 2). Chart 2Corporate Tax Rates Will Rise To 25%-28%, A Big Increase For Real Estate, Health Care, Tech, Utilities, And Consumer Staples It will take time to draft and negotiate the spending and tax provisions and then get them passed in both the House and Senate. The Democrats also face tight margins in the House, where they can only lose four votes (the balance in the House is 218-211 after the death of Florida Representative Alcee Hastings). The earliest possible passage – based on historical precedent – is in May. The average length of time would put passage in November. In the worst case the negotiations could drag on till Christmas but we highly doubt the Democrats will take that long (Diagram 1). We attach an 80% subjective probability to the view that the American Jobs Plan will pass by end of year. Diagram 1Time Line For Congress To Pass American Jobs Plan By End Of 2021 Where we are less certain is in the second part of Biden’s economic plan, the $1.9 trillion American Families Plan, which contains social welfare spending, an expansion of the child tax credit and other tax cuts for the lower and middle classes, and the tax hikes on upper-middle class and wealthy individuals and households. This program will be outlined this month. It will be a challenge to pass it prior to the 2022 midterm elections, depending on how fast infrastructure flies through Congress. Our subjective 50% odds received initial support on April 5 when the Senate parliamentarian, Elizabeth MacDonough, ruled that the Democrats can indeed pass more than one budget reconciliation bill per fiscal year, contrary to previous practice. This bill is just as likely to be the Democratic campaign platform for 2022 as to be passed in early 2022 under the current Congress. Senate Parliamentarian Enables Democrats To Bypass Filibuster We must pause here to note that the parliamentarian’s ruling is highly consequential as it erodes the checks and balances on passing legislation in the Senate. The new ruling holds that under Section 304 of the Congressional Budget Act of 1974 the annual budget resolution can be revised. If it can be revised, then a new budget reconciliation bill can be crafted according to the new budget resolution. And reconciliation enables the ruling party to push through bills on a simple majority (51 votes) in the Senate. It will be hard for the Senate, as a body, to limit the ramifications of this decision in future. If the Democrats can pass two reconciliation bills in FY2021, then who is to say that some later Congress cannot pass three? Regardless, it is hard for a party to pass more than three major pieces of legislation in a single year, so the window is just wide enough to enable major breakthroughs in legislation (and, whenever the opposing party regains the House and Senate, big reversals of legislation). We have argued that Democrats would eventually, if not immediately, remove the Senate filibuster (the rule that requires 60-votes to end debate on regular legislation). At the moment there are still not enough votes to remove the filibuster entirely, although moderate Democrats are looking at technical ways of diminishing its influence, such as via the “talking filibuster” that would increase the difficulty of the process and thus reduce its use in the Senate.1 But this new ruling on budget reconciliation process substantively bypasses the filibuster. While the reconciliation process will still come with various technical limitations (the “Byrd rule,” and relevance to the budget), they are pliable. Clearly the ruling party calls the shots – especially if it is a party in synch with the political establishment in Washington. The Public Favors Tax Hikes For Infrastructure Where do we get our 80% subjective probability that Biden’s American Jobs Plan will pass Congress? Why so confident? First, Democrats have control of Congress, albeit narrowly. Second, public opinion not only favors infrastructure but also favors tax hikes on corporations – especially if they are to pay for infrastructure. The solution has been to rebrand renewable energy, broadband Internet, subsidized housing, and a range of other government programs as “infrastructure,” and meanwhile to rebrand social welfare as “human infrastructure.” Consider the following: The public favors higher taxes on corporations: 69% of Americans believe corporations pay too little in taxes, while only 6% believe they pay too much (Chart 3). While this is a general view, and does not reflect regional variations, it calls into question Joe Manchin’s opposition to a corporate tax rate of 28%. Manchin has his eye on the economic recovery, small business owners, as well as the particular industries and political orientation of his state. But the point is that opposition to corporate tax hikes is politically weak and therefore we continue to expect the result to be closer to Biden’s 28% than to Manchin’s 25%. The public favors higher taxes on high-income earners: As for Biden’s second slate of tax hikes, on individuals and households under the yet-to-be detailed American Families Act, 62% of Americans believe that upper-income earners pay too little in taxes and again only 9% believe they pay too much (Chart 4). Since Biden’s proposals amount to only a partial repeal of President Trump’s Tax Cut and Jobs Act, which was itself unpopular in opinion polling, investors should also have a presumption in favor of individual tax hikes. However, as noted above, the American Families Plan only has a 50% chance of passing prior to the midterms due to the time crunch. Chart 3Public Favors Tax Hikes On Corporations Chart 4Public Favors Tax Hikes On The Rich Government is not seen as incompetent on infrastructure: Net public approval of the government’s performance on infrastructure is positive, just barely, unlike immigration, health care, or the environment. This means Biden can tap into a greater level of trust in government on this policy, while still calling on a general belief that infrastructure needs to be improved (Chart 5). Chart 5Public Gives Government Decent Grades On Infrastructure Chart 6No Partisan Gap On whether Infrastructure Should Be Prioritized Infrastructure is bipartisan: The gap in the views of Republicans and Democrats is narrow when it comes to infrastructure, unlike other policy issues that are extremely polarized. The gap is narrow whether infrastructure should be prioritized (Chart 6), whether government should play a larger role (Chart 7), and whether the federal government does a good job in this area (Chart 8). Democrats are more supportive of these propositions and they are currently in charge. But even Republicans tend to agree, as indicated by President Trump’s own emphasis on infrastructure, which the grassroots of his party supported despite establishment Republican hesitations due to concerns about the deficit. These charts also suggest that voters, especially Democratic voters, will not be bothered by the presence of non-traditional or “soft” infrastructure in Biden’s package as long as it can be successfully pitched as helping the economy, jobs, and American supply chains. Chart 7Government Role In Infrastructure Not Too Partisan Chart 8Government Performance On Infrastructure Not Too Partisan The public approves of Biden’s corporate-tax-hikes-for-infrastructure tradeoff: About 54% approve outright, in line with Biden’s overall approval rating, including 52% of independents and a non-negligible 32% of Republicans. A further 27% support infrastructure spending without raising taxes, including 42% of Republicans (Chart 9). This poll does not stand alone but corroborates a range of polling over the past decade on both taxes and infrastructure. It strongly implies that the median voter will support Biden’s plan. (And again it suggests that while Senator Manchin may turn the balance in the Senate he is not standing on solid rock in calling for Biden to pare back his corporate tax hikes.) Chart 9Voters Back Tax Hikes For Infrastructure No need to rely on polling – look at how people vote: Ballot measures on the local level for transportation funding usually win high levels of voter approval, meaning that people vote to increase their own taxes if they think traditional infrastructure will be improved. The average approval for such measures stood at 74% in 2016 and rose to 94% in the 2020 election cycle (Chart 10). And voters clearly understood that this combination is what they would get in voting for Biden, given that he did not shy away from his tax proposals in the presidential debates (although he insisted no tax hikes on those who earn less than $400,000 per year). Chart 10Voters Accept Higher Taxes For Infrastructure The Democrats have the votes for an infrastructure package, they have the votes for at least some degree of corporate tax hikes, and they have popular opinion behind the principle of tax hikes in exchange for infrastructure upgrades. Furthermore the rise of geopolitical struggle abroad and populism at home have given Biden and the traditional Democrats extraordinary impetus to pass this bill. If they fail, they will have wasted precious congressional time, they will be less likely to pass the American Families Plan, and they will be more likely to lose control of the House or even the Senate in 2022, as their failure would energize both the democratic socialists on their left and the Trump Republicans on their right. It is unlikely that Senator Manchin alone is willing or able to cause such a train wreck for his party given the popularity of the proposals.2 The implication is that corporate tax hikes will be compromised only somewhat. It is also possible that non-infrastructure components of the bill, such as housing or some social spending, could be pared back, although these are not the controversial parts of the bill and we would not bet on the overall size of spending to be reduced by much. A bill with Biden’s spending measures and only half of the tax hikes would increase the budget deficit by $1.4 trillion, as we showed last week. A bill with all spending and all tax hikes would increase the deficit by $400 billion. Bottom Line: Biden has an 80% chance of passing the American Jobs Act, although some non-infrastructure provisions could be pared back and the corporate tax hike may not reach all the way to 28%. Most likely the final bill will be substantially similar to Biden’s proposal on spending, while the tax hikes will be compromised, reflecting the populist and proactive fiscal turn in US politics. Investment Takeaways A basket of the 50 companies in the S&P 500 with the highest median effective tax rates outperformed the S&P500 upon Trump’s election and subsequent tax cuts (Chart 11). Since Biden’s election they have also outperformed on the expectation of post-pandemic reopening and economic stimulus. However, the high-tax companies and high-tax sectors have underperformed on an equal-weighted basis since the Democratic Party won control of the Senate and tax hikes became inevitable. Tax hikes are largely but not fully priced from this point of view. Historically a rising budget deficit does not have a clear or positive correlation with the S&P 500, cyclical sectors, value stocks, or small caps. Fiscal thrust normally surges during recessions and bear markets. Nevertheless infrastructure plays – by which we include building products, construction materials and services, environmental services, metals and mining, machinery, and steel – tend to perform better when the deficit blows out. That trend looks to be intact today (Chart 12). Chart 11High-Tax Companies Rallied Despite Biden's Tax Hikes (But Not On Equal-Weighted Basis) Chart 12US Budget Blow-Out Positive For Infrastructure Plays The budget deficit is generally a stronger predictor of the performance of these sub-sectors than global manufacturing surveys and leading economic indicators, although the improvement in global sentiment and growth is clearly a positive backdrop (Chart 13). Europe and countries other than China will soon improve their vaccinations, reopen, and start catching up to the US economic rebound. China’s fiscal-and-credit impulse is closely correlated with US infrastructure plays and this has not changed since the trade war began (Chart 14). Importantly, China is tapping on the policy brakes and its economy is set to decelerate in the second half of the year, which has important implications for our BCA Infrastructure Basket and long trades. This indicator suggests that the relative performance of infrastructure plays will face a gradually rising headwind from abroad even as the US economy continues to provide a tailwind. Chart 13Global Sentiment Positive But Not A Big Driver Of US Infrastructure Plays Chart 14Infrastructure Plays Face Headwind From China's Waning Stimulus Infrastructure plays shown here – which consist of goods and services that fall under greater demand when infrastructure is built – should not be confused with infrastructure companies themselves, which tend to be classified under the much more defensive utilities and telecommunication sectors (Chart 15). This ratio is looking very toppy, in keeping with the general rollover in cyclical equity sector performance relative to defensives.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 15Infrastructure Plays Versus Utilities And Telecoms   Appendix Table A1Political Risk Matrix Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments   Footnotes 1     Molly E. Reynolds, “What is the Senate filibuster, and what would it take to eliminate it?” Brookings Institution, September 9, 2020, brookings.edu. 2     On the contrary, while the bill will pass via party-line voting, it is still conceivable that one or two moderate Senate Republicans could be brought to endorse Biden’s American Jobs Plan.  

Feature The selloff in Chinese stocks since mid-February reflects a rollover in earnings growth and multiples. Lofty valuations in Chinese equities driven by last year’s massive stimulus means that stock prices are vulnerable to any pullback in policy supports (Chart 1A and 1B). Chart 1AGrowth In Chinese Investable Earnings And Multiple Expansions Has Rolled Over Chart 1BEarnings Outlook Still Looks Promising In The Onshore Market, But May Soon Peak After diverging in the past seven to eight months, Chinese stocks have started to gravitate towards deteriorating monetary conditions index. The market may be beginning to price in a peak in economic as well as corporate profit growth (Chart 2). Defensive stocks in China’s onshore and offshore equity markets have also outperformed cyclicals since February, which confirms that investors expect earnings growth will slow in the coming months (Chart 3). A tighter monetary policy stance, coupled with increased regulations targeting the real estate, banking, and tech sectors have further dampened investors’ appetite for Chinese stocks. Chart 2A-Share Prices Start To Gravitate Towards Tightening Monetary Conditions Chart 3Defensives Have Prevailed Over Cyclicals In Both Onshore And Offshore Markets The official PMIs bounced back smartly in March following three consecutive months of decline. However, the strong PMI readings do not change our view that the speed of China’s economic recovery is near its zenith. PMIs in the first two months of the year are typically lower due to the Lunar New Year (LNY), and the improvement in March’s PMI did not exceed seasonal rebounds experienced in previous years. Weakening fixed-asset investments also indicate that economic activity is moderating. We remain cautious on the 6 to 12-month outlook for Chinese stocks, in both absolute and relative terms. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     China’s NBS manufacturing and non-manufacturing PMIs in March beat market expectations with sharp rebounds after moderating in the previous three months. The improvement in the PMIs will likely provide authorities with confidence to stay the course on policy normalization. The methodology calculating PMI indexes reflects the net reported improvement in business activities relative to the previous month and there was a notable decline in PMIs in February, due to the LNY holiday and travel restrictions related to the spread of COVID-19.  Additionally, the average reading of China’s official composite PMI in Q1 this year was 2.2 percentage points lower than in Q4 last year and weaker than the Q1 PMI figures in most of the pre-pandemic years. Moreover, Chinese Caixin manufacturing PMI, which focuses on smaller and private corporates, declined further in March as it continued its downward trend started in December 2020. Chart 4Q1 PMIs Slowed By More Than Seasonal Factors Chart 5Caixin PMI Shows Further Deterioration Among Private-Sector Manufacturers Growth in credit expansions in February was better than expected, supported by a substantial increase in corporates’ demand for medium- and long-term loans. Travel restrictions during this year’s LNY led to a shorter holiday, a faster resumption in manufacturing activity after the break and stronger credit demand in February. China’s Monetary Policy Committee meeting last week reiterated the authorities’ hawkish policy tone and removed dovish language prevalent in last month’s National People’s Congress, such as “maintaining the consistency, stability, and sustainability in monetary policy” and “not making a sudden turn in policymaking.” Given the strong headline economic and credit data in January and February, the authorities will be unlikely to slow normalizing monetary policy. Therefore, the risk of a policy-tightening overshoot remains high. The PBoC has continued to drain net liquidity in the interbank system since early this year, evidenced by falling excess reserves at the central bank. Excess reserves normally lead the credit impulse by about six months, signaling that the latter will continue to decelerate in the months ahead. In turn, the credit impulse normally leads the business cycle by six to nine months, meaning that China’s cyclical economic recovery will likely peak in the first half of 2021. Chart 6Corporates Demand For Longer-Term Bank Loans Resumed Their Upward Trend Early This Year Chart 7Falling Excess Reserves Leads To A Deceleration In Credit And Economic Growth Robust industrial activities and improving profitability helped to boost profit growth in January and February. The bounce in producer prices also drove up returns in industrial output, particularly in upstream industries loaded with commodity producers. Nevertheless, weak final demand is limiting the ability of Chinese producers to pass on higher prices to domestic consumers, highlighted in the divergence between Chinese PPI and CPI. In addition, China’s domestic demand for commodities and industrial metals may reach its cyclical peak in mid-2021, following ongoing credit tightening and reduced economic activity. Commodity inventories have surged to historical highs due to soaring imports (which far exceeded consumption) during 2H20. Inventory destocking pressures will weigh on commodity prices with China’s domestic demand reaching its cyclical peak. Disinflation/deflation pressures may re-emerge in 2H21, which will pose downside risks to China’s industrial profits. Chart 8Industrials Posted A Strong Rebound In The First Two Months of 2021 Chart 9Surging Commodity Prices Helped To Boost Upstream Industry Profits Chart 10Domestic Final Demand Remains Sluggish Chart 11Decelerating Chinese Credit Growth Poses Downside Risks To Global Commodity Prices Chart 12Chinas Raw Material Inventory Restocking Cycle May Be Near A Cyclical Peak Chart 13Real Estate And Infrastructure Investment Losing Steam In 2021 Investments in infrastructure and real estate drove China’s economic recovery in the second half of 2020. However, growth momentum in both sectors has slowed because of retreating government spending in infrastructure and tightening regulations in the property sector. Both home sales and housing prices, especially in tier-one cities, rose significantly in January-February this year, deepening authorities’ concerns over bubble risks in the property market. The share of mortgages, deposits and advanced payments as a source of funds for property developers reached an all-time high in February. Following the LNY, the authorities introduced a slew of new restrictions on the housing market to curb excessive demand. These were in addition to placing limits on bank lending to both property developers and household mortgages. All of these measures will weigh on housing supply and demand, and the impact is already evident in falling land purchases and housing starts. At the same time, property developers are rushing to complete existing projects. The tighter regulations on real estate financing will likely weaken growth in real estate investment and construction activities in the second half of this year. Chart 14Housing Prices In Top-Tier Cities Have Been On A Tear … Chart 15… But Bank Lending To Developers And Mortgage Loans Continue Downward Trend Chart 16Property Developers Are Rushing To Sell And Complete Existing Projects Chart 17Forward-Looking Indicators Suggest A Slowdown In Housing And Construction Activities   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Cyclical Investment Stance Equity Sector Recommendations

Last week we highlighted BCA’s Risk Appetite Index (RAI) that has catapulted to uncharted territory. While such euphoria has not historically spelled cyclical or structural SPX trouble, it does warrant some near-term caution. Tack on the blockbuster non-farm payrolls and ISM manufacturing releases from last week and this week’s ISM services all-time high print and investors have further stampeded into stocks. Moreover, we recently showed that seasonality would boost the SPX in April before the dreaded month of May. Lastly, the equity put/call ratio collapsed to 0.38 on Monday, the VIX broke 18 and the SPX surpassed our end-2021 target of 4,000 (please look forward to receiving our SPX DDM update scheduled for the April 19 Strategy Report publication). Amidst such exuberance, and given that the 10-year US Treasury yield appears exhausted unable to breakout to fresh recovery highs, we are compelled to book handsome profits in our synthetic SPX long via closing the long $400/$420 call spread short $340 put on the SPY for June expiry for a gain of $8.86/contract or 2850% since the February 11 inception (middle panel). As a reminder, our previous synthetic long netted us $5.41/contract of 676% return as we managed to lock in gains before it fell to $0 at expiry (bottom panel). For clients that want to roll over the synthetic long position and continue to chase this manic market, we would recommend a long $415/$435 call spread with a short $365 put on the SPY for the August expiry at a net outflow of $0.2/contract. Bottom Line: Crystalize gains of $8.86/contract or 2850% and move to the sidelines on the SPX synthetic long position for now, but stay tuned. The SPX is now above our 4,000 yearend target and some near-term caution is warranted.   ​​​​​​​

Highlights The Biden Administration's $2.25 trillion infrastructure plan rolled out yesterday will, at the margin, boost global demand for energy and base metals more than expected later this year and next.  Global GDP growth estimates – and the boost supplied by US stimulus – once again will have to be adjusted higher (Chart of the Week). Energy and metals fundamentals continue to tighten. OPEC 2.0's so-far-successful production management strategy will keep the level of supply just below demand, which will keep Brent crude oil on either side of $60/bbl. Base-metals output will struggle to meet higher demand from the ongoing buildout of renewables infrastructure and growing electric-vehicle sales. Of late, concerns that speculative positioning suggests prices will head lower – or, at other times, higher – are entirely misplaced: Spec positioning conveys no information on price levels or direction.  Energy and metals prices, on the other hand, do convey useful information on spec positioning, demonstrating specs do not lead the news or prices, they follow them. Short-term headwinds caused by halting recoveries and renewed lockdowns – particularly in the EU – will fade in 2H21 as vaccines roll out, if the experience of the UK and US are any guide.  Continued USD strength, however, would remain a headwind. Feature If the Biden administration is successful in getting its $2.25 trillion infrastructure-spending bill through Congress, the US will join the rest of the world in the race to re-build – in some cases, build anew – its long-neglected bridges, roads, schools, communications and high-speed transportation networks, and, critically, its electric-power grid.  There's a lot of game left to play on this, but our Geopolitical Strategy group is giving this bill an 80% of passage later this year, after all the wrangling and log-rolling in Congress is done. In and of itself, the infrastructure-directed spending coming out of Biden's plan will be a catalyst for higher US industrial commodity demand – energy, metals and bulks.  In addition, it will support the lift in the demand boost coming out of higher GDP growth globally, which will be pushed higher by US fiscal spending, as the Chart of the Week shows.  Of note is the extremely robust growth expected in India, China and the US, which are among the largest consumers of industrial commodities globally.  Overall growth in the G20 and globally will be expansive in 2022 as well. Chart of the WeekBiden's $2.25 Trillion Infrastructure Bill Will Boost Global Commodity Demand Higher GDP growth translates directly into higher demand for commodities, all else equal, as can be seen in the relationship between EM and DM GDP, supply and inventories and Brent crude oil prices in Chart 2.  While we have reduced our Brent forecast for this year to $60/bbl on the back of renewed demand-side weakness in the EU due to problems in acquiring and distributing COVID-19 vaccines, we expect this to be reversed next year and into 2025, with prices trading between $60-$80/bbl (Chart 3).  OPEC 2.0, the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, has done an excellent job of keeping the level of oil supply below demand over the course of the pandemic, which we expect to continue to the end of 2025.1 Chart 2Higher GDP Growth Presages Higher Commodity Demand Chart 3Brent Crude Oil Prices Will Average - / bbl to 2025 As the Biden plan makes its way through Congress, markets will get a better idea of how much diesel fuel, copper, steel, iron ore, etc., will be required in the US alone.  What is important to note here that the US is just moving to the starting line, whereas other economies like China and the EU already have begun their investment cycles in renewables and EVs.  At present, key markets already are tight, particularly copper (Chart 4) and aluminum (Chart 5).  In both markets, we expect physical deficits this year and next, which inclines us to believe the metals leg of this renewables buildout is just beginning – higher prices will be required to incentivize the development of new supply.2  Chart 4Copper Will Post Physical Deficit... Chart 5...As Will Aluminum This is particularly important in copper, where growth in mining output of ore has been flat for the past two years.  Copper is the one metal that spans all renewables technologies, and is a bellwether commodity for global growth.  We expect copper to trade to $4.50/lb (up ~ $0.50/lb vs spot) on the COMEX in 4Q21 on the back of increasing demand and tight supplies – i.e., falling mining supply and refined copper output growth (Chart 6). Worth noting also is steel rebar and hot-rolled coil prices traded at record highs this week on Chinese futures markets.  Stronger steel markets continue to support iron ore prices, although the latter is trading off its recent highs and likely will move lower toward the end of the year as Brazilian supply returns to the market.3  We use steel prices as a leading indicator for copper prices – steel leads copper prices by ~ 9 months.  This makes sense when one considers steel is consumed early in infrastructure and construction projects, while copper consumption occurs later as airports and houses are fitted with copper for electric, plumbing and communications applications. Chart 6Copper Ore Output Flat   Does Speculative Positioning Matter? Of late, media pundits and analysts have cited an unwinding of speculative positions in oil and metals markets following sharp run-ups in net long positions as a harbinger of weaker prices in the near future (Chart 7).4  At other times, speculation has been invoked as a reason for price surges – e.g., when oil rocketed  toward $150/bbl in mid-2008, which was followed by a price collapse at the start of the Global Financial Crisis (GFC).5 Brunetti et al note, "The role of speculators in financial markets has been the source of considerable interest and controversy in recent years. Concern about speculative trading also finds support in theory where noise traders, speculative bubbles, and herding can drive prices away from fundamental values and destabilize markets." (p. 1545) Chart 7Speculative Positioning Lower In Brent Than WTI We recently re-tested earlier findings in our research, which found that knowledge of how specs are positioned – either on the long or the short side of the market – conveys no information on the level of prices or the change that should be expected given that knowledge.  However, knowledge of the price level does convey useful information on how speculators are positioned in futures markets.6 In cointegrating regressions of speculative positions in crude oil, natural gas and copper futures on price levels for these commodities, we find the level of prices to be a statistically significant determinant of spec positions. We find no such relationship using spec positions as an explanatory variable for prices.7 On the other hand, Chart 2 above is an example of statistically significant relationships for Brent and WTI price as a function of supply-demand fundamentals displaying coefficients of determination (r-squares) of close to 90% in the post-GFC period (2010 to now).  This supports our earlier findings regarding spec behavior: They follow prices, they don't lead them.8 We are not dismissive of speculation.  It plays a critical role in markets, by providing the liquidity that enables commodity producers and consumers to hedge their price exposures, and to investors seeking to diversify their portfolios with commodity exposures that are uncorrelated to their equity and bond holdings.  Short-Term Headwinds Likely Dissipate COVID-19 remains the largest risk to markets generally, commodities in particular.  The mishandling of vaccine rollouts in the EU has pushed back our assumption for demand recovery deeper into 2H21, but it has not derailed it.  We expect COVID-related deaths and hospitalizations to fall in the EU as they have in the UK and the US following the widespread distribution of vaccines, which should occur in the near future as Brussels organizes its pandemic response (Chart 8).  Making vaccines available for other states in dire straits will follow, which will allow the global re-opening to progress as lockdowns are lifted (Chart 9). Chart 8EU Vaccination Rollouts Will Boost Global Economic Recovery Chart 9Global Re-Opening Has Slowed, But Will Resume In 2H21 The other big risk we see to commodities is persistent USD strength (Chart 10).  The dollar has rallied for the better part of 2021, largely on the back of improving US economic prospects relative to other states, and success in its vaccination efforts.  The resumption of the USD's bear market may have to wait until the rest of the world catches up with America's public-health response to the pandemic, and the global economy ex-US and -China enters a stronger expansionary mode. Bottom Line: We remain bullish industrial commodities expecting demand to improve as the EU rolls out vaccines and begins to make progress in arresting the pandemic and removing lockdowns.  Global fiscal and monetary policy, which likely will be bolstered by a massive round of US infrastructure spending beginning in 4Q21 will catalyze demand growth for oil and base metals.  This will prompt another round of GDP revisions to the upside.  The dollar remains a headwind for now, but we expect it to return to a bear market in 2H21. Chart 10The USD's Evolution Remains Important   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 Going into the April 1 meeting of OPEC 2.0 today, we are not expecting any increase in production.  OPEC earlier this week noted demand had softened, mostly due to the slow recovery from the COVID-19 pandemic in the EU, which, based on their previous policy decisions, suggests the producer coalition will not be increasing production.  The coalition led by KSA and Russia will have to address Iran's return as a major exporter to China this year, which appears to have been importing ~ 1mm b/d of Iranian crude this month (Chart 11).  This puts Iran in direct competition with KSA as a major exporter to China, in defiance of the US re-imposition of sanctions against Iranian exports.  China and Iran over the weekend signed a 25-year trade pact that also could include military provisions, which could, over time, alter the balance of power in the Persian Gulf if Chinese military assets – naval and land warfare – deploy to Iran under their agreement.  Details of the deal are sparse, as The Guardian noted in its recent coverage.  Among other things, government officials in Tehran have come under withering criticism for entering the deal, which they contend was signed with a "politically bankrupt regime."  The Guardian also noted US President Joe Biden " is prepared to make a new offer to Iran this week whereby he will lift some sanctions in return for Iran taking specific limited steps to come back into compliance with the nuclear agreement, including reducing the level to which it enriches uranium," in the wake of the signing of this deal. Base Metals: Bullish Copper fell this week, initially on an inventory build, and has now settled right under the $4/lb mark, as investors await details on the US infrastructure bill unveiled in Pittsburgh, PA, on Wednesday.  According to mining.com, a major chunk of the proposed bill will be devoted to investments in infrastructure, which will be metals-intensive.  Precious Metals: Bullish Gold fell further this week, as US treasury yields rose, buoyed by the increased US vaccine efforts and President Biden’s proposed spending plans (Chart 12). USD strength also worked against the yellow metal, which has been steadily declining since the beginning of this year.  COMEX gold fell below the $1,700/oz mark for the third time this month and settled at $1,683.90/oz on Tuesday. Chart 11 Chart 12     Footnotes 1     Please see Five-Year Brent Forecast Update: Expect Price Range of $60 - $80/bbl, which we published 25 March 2021.  It is available at ces.bcaresearch.com. 2     Please see Industrial Commodities Super-Cycle Or Bull Market?, which we published 4 March 2021 for additional discussion, particularly regarding the need for additional capex in energy and metals markets. 3    Please see UPDATE 1-Strong industrial activity, profit lift China steel futures, published by reuters.com 29 March 2021. 4    See, e.g., Column: Frothy oil market deflates as virus fears return published 23 March 2021. 5    Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), " Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74, for further discussion. 6    Please see Specs Back Up The Truck For Oil, which we published 26 April 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility published 10 May 2018.  Both are available at ces.bcaresearch.com. 7     We group money managers (registered commodity trading advisors, commodity pool operators and unregistered funds) and swap dealers (banks and trading companies providing liquidity to hedgers and speculators) together to test these relationships. 8    In our earlier research, we also noted our results generally were supported in the academic literature.  See, e.g., Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012), "The Role of Speculation in Oil Markets: What Have We Learned So Far?" published by The Oxford Institute For Energy Studies.   Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights President Biden’s $2.4 trillion “American Jobs Plan” is a major US public investment that will dispel any endogenous deflationary tail risk from the US economy this cycle, increase inflation expectations yet boost productivity, and hike corporate taxes. The proposal has an 80% chance of passage before the end of the year given that infrastructure is popular and Democrats can pass the bill via reconciliation with zero Republican votes.   The $2.4 trillion infrastructure proposal will take effect over eight years and will be offset by corporate tax hikes that will take effect over 15 years. The increase in the budget deficit will be around $400 billion if all tax hikes pass and $1.4 trillion if only half the tax hikes pass. The American Families Plan will follow with another roughly $700 billion to $1.3 trillion increase to the budget deficit, depending on how much individual/household taxes go up. But this bill only has a 50/50 chance of passing before the 2022 midterm elections. Investors should maintain a bullish cyclical (12-month) bias and keep favoring value stocks, industrials, and materials over tech and health care. We also recommend going long consumer discretionary stocks and energy large caps versus small caps. Feature President Joe Biden spoke in Pittsburgh on Wednesday to unveil his economic vision and policy proposals going forward. Biden proposed a $2.4 trillion “American Jobs Plan” infrastructure and green energy package to be implemented over eight years, which will be part of a $4 trillion-plus “Build Back Better” legislative agenda that will be partially offset by an estimated $3 trillion in tax hikes to take effect over 15 years. The result will be a pro-cyclical boost to fiscal thrust, GDP growth, and inflation expectations; some potential for a productivity boom; a possible expansion of the social safety net; and tax reform that reduces US corporate profits. Pennsylvania is a Rust Belt state, Biden’s home state, and a critical swing state in the 2016 and 2020 elections, so the location makes sense. Biden aims to solidify the economic recovery and restore the Democratic Party’s leadership on infrastructure and manufacturing after Republican President Trump nearly stole their thunder. If he succeeds then his administration and party will improve their support substantially. The US economy is opening rapidly while the COVID-19 vaccination campaign continues apace. Chart 1 shows that household disposable income and net worth surged as a result of giant fiscal relief while consumer spending lags behind due to social distancing. The $1.7 trillion treasure chest of personal savings creates the basis for an increase in spending as consumers get vaccinated and regain their freedom. Economic policy uncertainty has collapsed, even relative to global uncertainty (Chart 2). There are no longer doubts about whether government will spend the country out of a slump. Even state and local governments have been bailed out despite having much stronger finances than predicted. However, there are doubts about how much more deficit spending the Biden administration will be able to push through, and that is what will now be debated in Congress following Biden’s Pittsburgh proposals. Chart 1Lower Spending And Higher Income Led To Mounting Excess Savings Chart 2US Policy Uncertainty Soon To Revive There will not be much of a deflationary tail risk to the new business cycle in the context of this expansive fiscal policy, as bullish investors are well aware. However, policy uncertainty will revive going forward as more spending will raise the risk of economic overheating, tax hikes will affect different sectors disproportionately, deficits and debt will balloon, and Biden’s challenges with immigration and foreign policy will intensify. There is an upside risk for the stock market that Congress delays tax hikes but this is not our base case. In this week’s report we revise and update our estimates for the impact of Biden administration’s legislative proposals – including his projected $4 trillion-plus in spending on infrastructure, health, and education – taking into consideration Biden’s Pittsburgh speech, his first press conference on March 25, and all the rumors and leaks that have come to light over the past two weeks. Back-Of-The-Envelope Estimates Of US Growth And Output Gap After ARPA First we need to revise our back-of-the-envelope estimates of the impact of the $1.9 trillion American Rescue Plan Act (ARPA). Chart 3 shows two scenarios for US GDP growth. The first is the “maximum” scenario, in which US real GDP grows by 10.7% because all of the money authorized under the new law is spent. The second scenario puts real growth at 6% by using only the Congressional Budget Office’s expected federal outlays (as opposed to budget authority) to estimate the government spending component of GDP. In both cases we assume that 33% of the fiscal relief is spent in FY2021 and the remainder in FY2022. These scenarios do not include Biden’s American Jobs and Families Plans because those bills have yet to be drafted, let alone pass Congress. Chart 3Revised US GDP Estimates With ARPA Consensus estimates put real GDP growth at 5.7% and the Federal Reserve estimates that 2021 growth will clock in at 6.5%, as shown in Chart 4. Not all of the government spending will translate directly into aggregate demand because 37% of the ARPA consists of direct checks and unemployment benefits to households that may only spend one-third of the amount they receive (while paying down debt with a third of it and saving a third of it). Yet more government deficit spending is coming down the pike and consumers are sitting on a huge pile of savings, which implies that growth could surprise to the upside of consensus estimates. Chart 4Consensus Estimates Of US GDP PosT-ARPA Chart 5 uses our same back-of-the-envelope calculation to estimate the impact of current law (including ARPA) on the US output gap. The output gap is the difference between actual GDP growth and potential GDP growth – during busts the country’s growth falls well beneath potential while during booms it rises above potential. The chart shows that if all of the government relief funds are spent then the output gap will be more than closed by the end of the year. By contrast, the CBO’s January projection shows the output gap persisting through 2025. While our estimates in Chart 5 may be too generous regarding federal cash handouts translating directly to consumer spending and higher demand, nevertheless the consensus estimate is entirely understated and out of date as a result of ARPA and the Biden administration’s additional fiscal spending that is coming. Chart 5Revised US Output Gap Estimates With ARPA Chart 6Revised US Budget Deficit Projection Post-ARPA Chart 6 updates our US budget deficit outlook using the CBO’s February budget baseline. The ARPA’s increase in government spending is added to create the new Democratic Party status quo scenario over the next ten years, with the budget normalizing by 2025. The Democratic low spending scenario assumes that Biden passes the $2.4tn infrastructure-plus plan announced in Pittsburgh (Table 1) using all the revenue from all the corporate tax hikes. Biden’s agenda will be broken into separate bills with varying probabilities of success. So in our budget deficit outlook we only include the infrastructure-and-corporate-tax-hikes component that is apparently being prioritized. Table 1Biden's 'American Jobs Plan' Bottom Line: US growth will surprise to the upside of consensus estimates while the US output gap will be closed much sooner than expected. Financial markets are largely prepared for this outcome, although it reinforces that investors should maintain a cyclically bullish view and tactically should buy on the dips. Biden’s Pittsburgh Speech And ‘American Jobs Plan’ Budget Impacts Our view is that the Biden administration has a subjective 80% chance of passing a second major budget reconciliation bill (FY2022) and a 50% chance of passing a third budget reconciliation bill (FY2023). The question appears to be resolved that Democrats will prioritize infrastructure over social welfare. Whichever one they prioritize can be linked to tax hikes and yet will still be highly likely to pass given that no Republican votes are needed under budget reconciliation rules. Moderate Democrats may water down the tax provisions but they would be suicidal to oppose their entire party on the administration’s signature piece of legislation. The social spending bill, assuming it follows infrastructure, would have to be pursued via a third reconciliation bill for FY2023 but it is less likely to pass. By next year Biden will have spent a lot of his political capital, fiscal spending fatigue will be a real phenomenon, and the 2022 midterm elections will loom. What matters for investors is the impact on the budget deficit since that will determine how big of an impact will hit GDP and how long US fiscal policy remains accommodative. Table 2 shows the impact on the budget balance if Biden gets all of his spending and all revenue proposals (Baseline), if he gets all the spending but only half the tax hikes (Scenario 1), and if he gets half the spending and half the tax hikes (Scenario 2). Scenarios 3 and 4 treat the social spending plan with varying degrees of tax revenue from the proposed individual tax hikes, while Scenarios 5 and 6 treat the infrastructure plan with varying tax revenue from corporate tax hikes. Table 2Biden’s Forthcoming ‘American Jobs Plan’ Legislative Proposals Table 3 shows the Biden campaign’s proposed tax hikes by line item along with the spending proposals. The range of net deficit spending runs from about $400 billion to about $3 trillion over ten years, which is a broad range and not very telling but which seems, subjectively, likely to settle in the $2 trillion range. Chart 7 shows the budget deficit’s deviation from the status quo trajectory in each of these scenarios, i.e. additional fiscal thrust. Table 3Biden’s Tax-And-Spend Proposals In Detail Chart 7US Budget Deficit Projections With ‘American Jobs Plan’ Agenda The infrastructure package consists of a range of proposals having to do with traditional roads and bridges, renewable energy, rural broadband Internet, domestic manufacturing incentives, supply chain security initiatives, affordable housing, and research and development (see Table 1 above). The social safety net expansion consists of making permanent the child tax credit that was extended in the ARPA; lowering the Medicare eligibility requirement to age 60 from 65; lengthening paid family/medical leave for workers; funding universal pre-school; and funding tuition-free community college. Some Democrats will oppose delaying social spending and tax hikes because they may not pass before the midterms and Republicans could easily take back control of the House of Representatives in 2022. Hence there is still a chance that Biden will pursue infrastructure on a bipartisan and piecemeal basis while using the FY2022 budget reconciliation for his social spending and tax hikes. The reasoning goes as follows: Historically the House has a high probability of shifting against a new president’s party in his first midterm election. The only exception to this rule were George W. Bush and Franklin D. Roosevelt. Republicans will definitely oppose social welfare and tax hikes, whereas they could be convinced to support an infrastructure plan. Republicans will not vote for infrastructure if it includes tax hikes and many Democrats believe that long-term infrastructure spending will enhance productivity and hence need not require revenue offsets. Hence there is still a chance of a bipartisan infrastructure bill. This would jeopardize its overall passage but it would ensure that Democrats could pass their social agenda via FY2022 reconciliation. What are the odds of bipartisanship? Throughout this year we have reserved some space for bipartisan lawmaking to take place under the radar. A recent example is the Paycheck Protection Program (PPP) Extension Act of 2021, which Biden signed into law on March 30. This is a bipartisan extension of the small business emergency loan program that began under President Trump. Senate Majority Leader Mitch McConnell quashed objections from within his party to extending the program, which has substantial support from the National Federation of Independent Business.1 The result was a 92-7 vote majority in the Senate, showing that Republican cooperation is possible. The fact that Republicans also cleared the way for the use of earmarks, or pork barrel spending directed at a critical lawmaker’s constituency in exchange for his or her vote, also suggests that bipartisanship is possible, particularly on infrastructure. Republicans can also be brought to support efforts to secure supply chains and energize the US technological race with China, such as the $50 billion funding for semiconductor manufacturing, which could be part of a major infrastructure package or regular budget appropriations. The catch is that Republicans will not support tax hikes, unionization, IRS strengthening, workplace enforcement, or climate change policies pursued under the guise of infrastructure. As a result the Democrats are highly incentivized to bypass Republicans from the beginning and pursue their agenda through two separate reconciliation bills. Finally, Democrats still have the option of removing the Senate filibuster, enabling regular bills to pass with merely 51 votes. Investors should plan on this occurring despite the news media narrative suggesting that moderate Democrats do not want it to happen – the point is that it is not an invincible check on the ruling party’s power. Biden signaled in his first press conference on March 25 that he is willing to see the filibuster removed. Bottom Line: Democrats can pass most of their infrastructure and social safety net proposals via budget reconciliation bills for FY2022 and FY2023, without a single Republican vote. If they do so they can only spare three votes in the House and zero votes in the Senate – meaning that the devil is in the details. Their odds of passing the first are high at a subjective 80% but then their odds of passing the second are 50/50 at best. Thus it is not wise to bet against Democratic tax hikes or new spending. The net impact on the deficit will be negative and hence stimulating for the economy. Growth and inflation will surprise to the upside. Biden’s Political Capital Still Moderate-To-Strong Our argument above is based in great part on Biden’s political capital, which is moderate but likely to strengthen as consumer sentiment rises. Table 4 updates our US Political Capital Index. Political polarization is subsiding from extreme peaks, and business sentiment and economic conditions are improving (with a surge in capex intentions albeit rising concerns over regulation). Table 4Biden’s Political Capital Sufficient For Another Major Bill The weak spot is household sentiment as Biden’s approval rating is falling (normal for presidents as their honeymoon ends). However, consumer confidence is already picking up and will surely accelerate with vaccinations gaining ground, the dole being delivered, and the service sector reviving. Chart 8 shows that Biden’s approval rating is settling in the mid-50% range, which is substantially better than Trump’s at this time although worse than President Obama’s. Biden can be understood as a synthesis of these two predecessors given that he is coopting Trump’s agenda on fiscal spending, infrastructure, trade, and manufacturing while continuing Obama’s legacy on regulation, immigration, civil rights, and foreign policy. We expect Biden’s approval rating not to fall too far, unless he suffers a foreign policy disaster with China, Iran, or Russia, given that over 50% of voters will tend to support him as long as President Trump is the obvious alternative. Chart 9 suggests that Biden’s economic approval rating is weak but this score is going to rise once the new relief funds are distributed and the economic recovery gets going full steam. The early business cycle will probably be a constant source of support for the president over his four-year term. Chart 8Biden’s Approval Rating Fairly Stout Chart 9Biden’s Approval On Economy Will Rise Remarkably even the US Congress is gaining greater popular approval (Chart 10). This is very rare in modern times and could suggest that a major change is taking shape as Congress pursues populist fiscal policy under both Trump and Biden. Congress is handing out free money so people suddenly don’t hate it as much. There is a limit to how popular Congress will become and it will certainly not shake off its hard-earned reputation for gridlock and partisan rancor by suddenly exemplifying enlightenment and bipartisanship. But any rise in congressional approval is notable and would imply greater political capital for the current government and hence greater policy certainty for investors in the short run. Biden’s political capital is not yet suffering due to economic overheating as the latter has not yet happened – but it is a risk to monitor over the medium term. Inflationary pressures continue to build across the supply chain. Small businesses are increasingly flagging cost of labor as a rising concern while consumer price inflation is likely to pick up. Chart 10Congress Is Becoming More Popular Inflation expectations are critical and will take time to change. Americans think about inflation through prices at the pump. Chart 11 shows the US and global crude oil price and average gasoline prices at the gas station for US consumers. Gasoline prices have surged although they are not yet at the $4 per gallon level that causes popular concern to escalate sharply. Chart 11Inflation Is Coming But Geopolitics Brings Oil Price Volatility Oil prices are expected to go higher in the coming two years, according to our Commodity & Energy Strategy, but over a five-year period global supply-demand trends and balances suggest that the price will fluctuate within the $60-$80 dollar range. Biden’s regulations and foreign policy will introduce some volatility by hampering domestic US production, triggering sparks in the Middle East over Iran, and yet ultimately increasing global supply via any diplomatic deal with Iran. The BCA Research House View holds that today’s inflation is a temporary phenomenon whereas a more substantial bout of inflation is waiting in the medium-to-long term. The reason our strategists are not overly concerned in the near term is that there is still substantial slack in the economy: the labor force participation rate has fallen from 63.3% to 61.4% since the pandemic, the U6 unemployment rate stands at 11.1% (up from 7% prior to the pandemic), and the all-important employment-to-population ratio for prime-age workers stands at 57.6%, down from 61.1% prior to the pandemic. However, this slack is on pace to be tightened quickly as long as the pandemic subsides and Biden’s American Jobs Plan passes. Bottom Line: Our US Political Capital Index suggests Biden’s political capital is moderate-to-strong, which supports our view that he can pass at least one more major piece of legislation and possibly two. Inflation expectations will rise further and the selloff in US treasuries will continue. Investment Takeaways The market rally since January has priced a lot of the good news from Biden’s proposals, which are broadly similar to his campaign proposals. There is not a clear legislative strategy and passing two major bills before the midterm elections is a stretch. The priority bill, however, looks to pass by the end of this year after a roller-coaster ride of congressional negotiations and horse-trading. Deep cyclical sectors will benefit the most. We remain long value over growth stocks, specifically industrials and materials. We are also maintaining our long BCA infrastructure basket at least until passage of the bill is secured. Our infrastructure basket consists of a range of materials and machinery producers, construction services, and environmental services, and does not focus on headline “infrastructure” companies in the utilities and telecoms sectors. We recommend going long large cap energy stocks relative to small caps, which will have a harder time adjusting to Biden’s regulatory, tax, and green agenda. A long-term infrastructure plan that includes green energy, manufacturing, digital infrastructure, and R&D could create a productivity boost. Hiking the corporate tax rate to 28% is negative for corporate earnings but it will take place over a longer time frame and is being introduced in the context of a cyclical upswing. Hence we remain bullish over the course of this year. Biden’s Pittsburgh speech ostensibly confirmed the news flow over the past month suggesting that the Democrats will not propose a government-provided health insurance option in their upcoming legislative proposals. Instead they are prioritizing lowering the Medicare eligibility requirement and enabling Medicare to negotiate pharmaceutical prices. Our short of the managed health care sub-sector suffered from this shift in policy focus although we will maintain the trade as we expect the public option to reemerge at a later date. Meanwhile our pair trade of long health equipment and facilities relative to pharmaceuticals and bio-tech continues to perform well (Chart 12). A clear beneficiary of the US’s newfound proactive fiscal policy is the consumer. Consumer spending has not fully recovered from the pandemic and recession. Household disposable income ticked down in February from January, after the distribution of the government’s $900 billion COVID-19 relief funds in the Consolidated Appropriations Act passed in December. However, disposable income is up 8% over the 12 months since COVID broke out, due to fiscal relief. The result of lower spending and higher income is an increase in the personal saving rate to 13.6% in February, well above normal, as our US Bond Strategy highlights in its latest report. Recent research from our US Investment Strategy highlights that consumer growth should track relatively well with increases in household net worth, implying that nominal personal consumption expenditures could grow at a rate of 8.8% by the end of the year and 6.9% by the end of next year. Chart 12Stay Long Industrials Over Health Care Chart 13Go Long Consumer Discretionary Stocks In this context we take a positive view of consumer stocks in general. Cyclically we would favor consumer discretionary stocks and recommend investors go long. While discretionary spending should outperform as the economic upswing gains pace, we are holding consumer staples as a hedge against bad news (Chart 13). Not only will Biden’s tax hikes, inflation, and the rise in bond yields cause ongoing risks to cyclical sectors, but Biden also faces a series of imminent foreign policy tests with China/Taiwan, Iran, Russia, and North Korea, as highlighted in our sister Geopolitical Strategy.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Table A2APolitical Capital: White House And Congress Table A2BPolitical Capital: Household And Business Sentiment Table A2CPolitical Capital: The Economy And Markets Table A3Biden’s Cabinet Position Appointments   Footnotes 1     Bill Scher, “The Bipartisan Senate Bill You Haven’t Heard About,” Real Clear Politics, realclearpolitics.com.          

We recently came across an old BCA indicator – the Risk Appetite Index (RAI) – and after dusting it off we tweaked it a bit and are updating it today for the first time since US Equity Strategy last showed it in 2007! The RAI comprises eight equally weighted risk on and off indicators shown as a z-score and constructed so that a rising value indicates increasing risk appetite and vice versa. For example, a rising VIX indicates risk off and thus is inverted as part of the RAI. Currently the RAI has literally gone off the charts and signals that investors are craving risk. True, previous nose bleed readings have been associated with significant market tops including late-1990s, mid-2008 and late-2019 RAI readings over one (see chart). However, the last time the RAI was over four standard deviations above the historical mean was during the GFC rebound from late-2009/early-2010 when the SPX also had a monster run-up as we recently showed in our research. Excessive leverage and the January Melvin Capital and more recent Archegos Capital Management blowup anecdotes are unnerving, and in the near-term some caution is warranted (as a reminder, we continue to hold the long VIX June futures as a hedge). However, more often than not such a high RAI reading has been resolved with an SPX correction and not a meltdown. As we have been highlighting recently, our biggest risk, aside from China’s slowdown, remains the Fed becoming at the margin less accommodative in the back half of the year when it will start talking about talking about tapering. Bottom Line: While the SPX is getting close to our 4,000 year-end target and some near-term caution is warranted, the equity bull market (and business cycle) is in its infancy and we reiterate our cyclical and structural sanguine views.  

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Chart 6Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Global Economy Chart 18US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

In the latest Special Report we attempted to answer the question of whether this coming rebound in CPI is a paradigm shift that will push the US into a new era of consistently high (i.e. above 3%/annum) core CPI inflation, or is it a merely counter trend inflationary spike within the broader deflationary megatrend? We took a deep dive into six structural forces behind inflation that we identified. Four of those forces were pro-inflationary, while the remaining two were anti-inflationary (Table 1). We also assigned a value on our subjective strength scale for each force. Each value incorporates how quickly a particular force will come to fruition, and how strong it will be over the next 5-to-10 year period. Based on our analysis, we concluded that there are rising odds that the deflationary megatrend has run its course and has reached an inflection point of turning inflationary. Bottom Line: On a structural basis (10-years), it is likely that the deflationary trend is turning. For more details please refer to this Monday’s Special Report.

Highlights Extremely accommodative fiscal policy and a rapid pace of vaccination puts the US on track to close its output gap by the end of the year. The situation is different in Europe, and the euro area economy will likely continue to underperform the US until at least the summer. Investors are now unusually more hawkish than the Fed, whose caution is driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. The Fed’s rate projections, coupled with the extraordinary size of the American Rescue Plan, have stoked investor concerns about a significant rise in inflation. For inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. We expect a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. We recommend that investors maintain below-benchmark portfolio duration, and overweight US speculative over investment-grade corporate bonds. The fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar over the coming 0-3 months. But over a 6-12 month time horizon, we continue to favor global ex-US vs. US stocks, and expect the dollar to be lower than it is today. A Brighter Light At The End Of The Tunnel Chart I-1Even Better Than Some Optimists Would Have Predicted Over the past 4-6 weeks, the US has continued to make incredible progress in vaccinating its population against COVID-19. Chart I-1 highlights that the pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the US will have vaccinated 90% of its population by the end of September (if it is determined that the vaccine is safe to give to children). And these calculations assume the continuation of a two-dose regime, meaning that the eventual rollout of Johnson & Johnson's Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further. The situation is clearly different in Europe. The vaccination progress in several European countries is woefully behind that of the US and the UK (Chart I-2), and per capita cases in the euro area have again risen significantly above that of the US (Chart I-3). This reality motivated last week’s news that the European Union is reportedly planning on banning exports of the AstraZeneca vaccine for a period of time, as European policymakers grow increasingly concerned about the potential economic consequences of lengthened or additional pandemic control measures over the coming few months. Chart I-2Europe Is Badly Lagging The Vaccine Race… There was at least some positive economic news from Europe this month, as reflected by the flash manufacturing and services PMIs (Chart I-4). The euro area manufacturing PMI surpassed that of the US this month, reflecting that the prospects for goods-producing companies in Europe remain solidly linked to the strong global manufacturing cycle. Services, on the other hand, have been the weak spot in Europe, having remained below the boom/bust line since last summer (in contrast to the US). The March services PMI highlighted that this gap is now starting to narrow, although the euro area economy will likely continue to underperform the US until at least the summer. Chart I-3...And It Is Starting To Show Chart I-4Some Closure Of The Services Gap, But Still A Ways To Go   The underperformance of the European services sector over the past nine months has been due in part to more severe pandemic control measures, but also a comparatively timid fiscal policy. The IMF’s October Fiscal Monitor highlighted that the US had provided roughly eight percentage points more of GDP in above-the-line fiscal measures versus the European Union as a whole, and that was before the US December 2020 relief bill and this month’s $1.9 trillion American Rescue Plan (ARP) act were passed. The CBO estimates that the ARP will result in about US$1 trillion in outlays in 2021, which is roughly 5% of nominal GDP. Consequently, Chart I-5 highlights that consensus expectations now suggest that the output gap will be marginally positive by the end of the year, with the Fed’s most recent forecast implying that real GDP will be more than 1% above the CBO’s estimate of potential output. Chart I-5The US Output Gap Will Likely Be Closed By The End Of This Year The Fed Versus The Market Despite this, the Fed held pat during this month’s FOMC meeting and did not validate market expectations of rate hikes beginning in early 2023. Chart I-6 highlights the Fed funds rate path over the coming years as implied by the OIS curve, alongside the Fed’s median projection of the Fed funds rate. This means that investors are now more hawkish than the Fed, which is the opposite of what has typically prevailed since the global financial crisis. Chart I-6The Market Is Now, Unusually, More Hawkish Than The Fed Fed Chair Jerome Powell implied during the March 17 press conference that some FOMC participants were unwilling to change their projections for the path of interest rates based purely on a forecast, which argues that the median dot in the Fed’s “dot plot” will shift higher in the second half of the year if participants’ growth and inflation forecasts come to fruition. But Charts I-7A and I-7B suggest that the Fed’s caution is also driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. Chart I-7AA Positive Output Gap Implies… Chart I-7B…An Unemployment Rate Below NAIRU   The charts highlight the historical relationship between the output gap and the deviation of NAIRU from the unemployment rate, from 2000 and 2010. In both cases, the charts show that the unemployment rate would be below the CBO’s estimate of NAIRU at the end of this year (roughly 4.5%) given the CBO’s estimate for potential (i.e. full employment) GDP and the Fed's forecast for growth. However, the Fed is forecasting that the unemployment rate will essentially be at NAIRU, which is itself above the Fed’s longer-run unemployment rate projection of 4%. As such, the Fed does not see the unemployment rate falling to “full employment” levels this year, a precondition for the onset of rate normalization. Investors should note that the relationships shown in Charts I-7A and I-7B suggest that the unemployment rate will be closer to 3-3.5% at the end of this year if the Fed’s growth forecast is correct, which would constitute full employment based on the Fed’s 4% unemployment rate target. The difference between a 3-3.5% unemployment rate and the Fed’s estimate of 4.5% translates to a gap of roughly 1.5-2.5 million jobs at the end of this year, which underscores that the Fed expects either a significant shift in temporary to permanent unemployment or an influx of unemployed workers back into the labor force who don’t quickly find jobs once social distancing ends and pandemic restrictions are no longer required. Chart I-8The Full Employment Level Of GDP Has Not Been Significantly Revised There are three possible circumstances that would resolve this seeming contradiction. The first is that the Fed’s estimate for growth this year is simply too high, and that the output gap will be close to zero at the end of the year (i.e., more in line with consensus market expectations). The second is that the CBO is understating the level of GDP that is consistent with full employment, namely that potential GDP is higher than what they currently project. But Chart I-8 shows that the CBO’s current estimate for potential output at the end of this year is only 0.4% below what it had estimated prior to the pandemic, which is smaller than the positive gap implied by the Fed’s growth estimate for this year (roughly 1.2%). The third possibility is that the Fed is overestimating the extent to which the pandemic will cause permanent damage to the labor market. As we noted in our February report, even once social distancing is no longer required, it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). A gap of 1.5-2.5 million jobs accounts for roughly 10-15% of pre-pandemic employment in retail trade, or 4-7% of the sum of retail trade, leisure & hospitality, and other services. It is possible that permanent job losses or significantly deferred job recovery of this size will occur, but it is far from clear that it will. Were job losses / deferred jobs recovery of this magnitude to not materialize, it would suggest that the US will reach full employment earlier than the Fed is currently projecting, and would significantly increase the odds that the Fed will begin to taper its asset purchases and/or raise interest rates at some point next year – which is earlier than investors currently expect. For Now, Dangerously Above-Target Inflation Is Unlikely Fed projections of a 0% Fed funds rate for the next 2 1/2 years, coupled with the extraordinary size of the American Rescue Plan, have understandably stoked investor concerns about a significant rise in inflation. Larry Summers’ recent interview with Bloomberg was emblematic of the concern, during which he criticized the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 It is true that the Federal Reserve is explicitly aiming to generate a temporary overshoot of inflation relative to its target, the Biden administration’s fiscal plan is legitimately large, and there is a tremendous pool of excess savings that could be deployed later this year once the pandemic is essentially over. Clearly, the risks of overheating must be higher than they have been in the past. But from our perspective, out-of-control inflation over the coming 12-24 months would very likely necessitate one of two things to occur, and possibly both: US consumers decide to spend an overwhelmingly large amount of the excess savings that have been accumulated. Main street expectations for consumer prices rise sharply, prompted by a public discussion about the likelihood of a shifting inflation regime. Our view is rooted in the examination of the modern-day Phillips Curve that we presented in our January report, which considers both the impact of economic/labor market slack and inflation expectations as a driver of actual inflation. The modern-day Phillips Curve posits that expectations act as the trend for inflation, and slack in the economy determines whether actual inflation is above or below that baseline. Chart I-9 highlights that the output gap worked well prior to the global financial crisis at explaining the difference between actual and exponentially-smoothed inflation, the latter acting as a long-history proxy for expectations. Pre-GFC, the chart highlights that there have been only two exceptions to the relationship that concerned the magnitude rather than the direction of inflation. Post-GFC, the relationship deviated substantially, but in a way that implied that actual inflation was too strong during the last expansion, not too weak – particularly during the early phase of the economic recovery. This likely occurred because expectations initially stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation, but ultimately declined due to a persistently negative output gap as well as in response to the 2014 collapse in oil prices (Chart I-10). Chart I-9Pre-GFC, The Output Gap Generally Explained Inflation Surprises Chart I-10Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Thus, for inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. Chart I-11 highlights that the amount of excess savings that have accumulated as a percentage of GDP does indeed significantly exceed the magnitude of the output gap, but some of those savings have been and will be invested in financial markets (boosting valuation), some will be used to pay down debt, some will eventually be spent on international travel (boosting services imports), and some will likely be permanently held as deposits in anticipation of future tax increases. And while long-term household expectations for prices have risen since the passing of the CARES act last year, the rise has merely unwound the decline that took place following the 2014 oil price collapse (Chart I-12). Chart I-11A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent Chart I-12Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base   For now, this framework points to a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Investment Conclusions Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. While the Fed is likely to shift in a hawkish direction compared with its current projections, it is highly unlikely to become meaningfully more hawkish than current market expectations unless economic growth and the recovery in the labor market is much stronger than the Fed or the market is projecting. In fact, even if the market’s expectations for the first Fed rate hike shift to mid-2022 over the coming several months, Chart I-13 highlights that the impact on the equity market is likely to be minimal unless investors shift up their expectations for the terminal Fed funds rate. The chart presents a fair value estimate for the 10-year Treasury yield based on the OIS-implied path of the Fed funds rate out to December 2024, and assumes that short rates ultimately rise to the Fed’s long-term Fed funds rate projection of 2.5%. The second fair value series assumes that the shape of the OIS curve stays the same, but shifts closer by 6 months. Chart I-13The Market’s Assumed Rate Hike Path And Terminal Rate Are Not Threatening For Stocks The chart underscores that the 10-year yield will rise to at most between 2-2.2% by the end of the year based on these scenarios. A shift forward in the timing of Fed rate hikes will impact the short end of the curve, but the long end will remain relatively unchanged if terminal rate expectations stay constant and the term premium on long-term bonds remains near zero. These levels would in no way be economically damaging nor threatening to stock market valuation. It is possible, however, that investor expectations for the neutral rate of interest (“r-star”) will shift higher once the pandemic is over, and we explore this risk to stocks in Section 2 of our report. For now, this remains a risk to our view rather than our expectation, but it is likely to remain an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Within fixed income, we recommend that investors maintain below-benchmark portfolio duration even though investors are already pricing in a more hawkish path for the Fed funds rate. First, Chart I-13 highlighted that yields at the long end of the curve are likely to continue to move modestly higher this year even if the projected path for the Fed funds rate remains relatively unchanged. But more importantly, barring a substantially negative development on the health or vaccine front that prolongs the pandemic, the risk appears to be clearly to the upside in terms of the timing of the first Fed rate hike and the terminal Fed funds rate. As such, from a risk-reward perspective, a long duration stance remains unattractive. We would also recommend overweighting US speculative over investment-grade corporate bonds, as spreads are not as historically depressed for the former than the latter (Chart I-14). Finally, in terms of the dimensions of equity market performance and the dollar, we recommend that investors overweight global ex-US equities vs. the US, overweight value vs. growth, overweight cyclicals vs. defensives, and overweight small vs. large caps. We are also bearish on the dollar on a 12-month time horizon. However, there are two caveats that investors should bear in mind. First, global cyclicals versus defensives (especially in equally-weighted terms) as well as small versus large caps have already mostly normalized not just the impact of the pandemic but as well that of the 2018-2019 Trump trade war (Chart I-15). We would expect, at best, modest further gains from both positions this year. Chart I-14Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Chart I-15Going Forward, Expect More Modest Gains From Cyclicals And Small Caps   Second, the fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar on a 0-3 month time horizon. The US dollar is typically a counter-cyclical currency, but there have been exceptions to that rule. And historically, exceptions have tended to revolve around periods when US growth has been quite strong, as is currently the case (Chart I-16). A continued counter-trend rally in the dollar is thus possible over the course of the next few months, but we would expect USD-EUR to be lower than current levels 12 months from now. Chart I-16A Short-Term Counter-Trend Dollar Move Is Possible A counter-trend dollar move could also correspond with a period of US outperformance versus global ex-US, or at a minimum, a period of flat performance when global ex-US stocks would normally outperform. Our China strategists expect that the Chinese credit impulse will decelerate later this year (Chart I-17), which would weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. Chart I-18 highlights that euro area equity underperformance versus the US last year was mostly a tech story, but today there is little difference between the relative performance of euro area stocks overall versus indexes that exclude the broadly-defined technology sector. In both cases, the euro area index is roughly 10% below its US counterpart relative to pre-pandemic levels, which exactly matches the extent to which euro area financials have underperformed. Chart I-17A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform Chart I-18Euro Area Financials Need To Outperform For Europe To Outperform   Euro area financials have demonstrated very poor fundamental performance over the past decade, but they are likely to outperform for some period once the European vaccination campaign gains enough traction to alter the disease’s transmission and hospitalization dynamics. Chart I-19 highlights that euro area bank 12-month forward earnings have further room to recover to pre-pandemic levels than for banks in the US, and Chart I-20 highlights that euro area banks trade at their deepest price-to-book discount versus their US peers since the euro area financial crisis. Chart I-19Euro Area Bank Earnings Have Catch-Up Potential Chart I-20Euro Area Banks Are Extremely Cheap Versus The US   Thus, while euro area and global ex-US equities may not outperform on the back of rising global stock prices over the coming few months, investors focused on a 6-12 month time horizon should respond by increasing their allocation to European stocks and to further reduce dollar exposure. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst March 31, 2021 Next Report: April 29, 2021 II. R-star, And The Structural Risk To Stocks In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,2 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have ticked slightly lower from their strongest levels on record. Within a global equity portfolio, US stocks have recently risen versus global ex-US, reflecting a countertrend rise in the US dollar and a lagging vaccination campaign in Europe. We expect a deceleration in the Chinese credit impulse later this year, which will weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. The US 10-Year Treasury yield has risen well above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields could move higher over the cyclical investment horizon. The recent bounce in the US dollar has reflected improved relative US growth expectations, but also previously oversold levels. The dollar may continue to strengthen on a 0-3 month time horizon, but we expect it to be lower in 12 months’ time than it is today. Commodity prices have recovered not just back to pre-pandemic levels, but also back to 2014 levels. This underscores that many commodity prices are extended, and may be due for a breather once the Chinese credit impulse begins to decline. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. This underscores that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Neutral In light of the likely slowdown in Chinese data, last week we downgraded the S&P machinery index from overweight to neutral. This sub-surface industrials sector move also comes on the heels of our previous upgrade in the more domestically focused S&P railroads index, and does not affect the broad sector’s overweight stance. As China goes, so do machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (not shown). Adding that to the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the risk/reward of being overweight machinery stocks loses traction (see chart). Bottom Line: We reiterate our recent downgrade on the S&P construction machinery & heavy trucks index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB. ​​​​​​​