United States

We have been inundated with client requests on how to best position for President Biden’s sweeping infrastructure spending package. We therefore constructed the BCA Biden Fiscal Advantage Basket, which comprises eight ETFs and one stocks, all equal weighted (top panel). Instead of buying specific stocks we opted to go the ETF way in order to diversify away company specific risk. Our goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, we tried to match the different spending segments of Biden’s preliminary bill (that our sister BCA US Political Strategy expects to pass Congress with high conviction) with an ETF. The ticker symbols of the eight ETFs and one stock we included in this Equity Basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs, and in certain ETFs there is a sizable international stock exposure including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this Basket should outperform the SPX on a cyclical and structural basis (middle panel). However, given the high tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ (bottom panel). Bottom Line: Initiate a long BCA Biden Fiscal Advantage Basket/short QQQ pair trade. On April 26, 2021 we will publish a joined SR with our sister US Political Strategy service on President Biden’s infrastructure spending bill proposal and elaborate further on this Equity Basket. The ticker symbols for the stocks in the BCA Biden Fiscal Advantage Basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. The table in the appendix on the next page shows a number of other related ETFs that did not make our cut, but that you may find interesting to research further.  

Highlights Structural headwinds are still too strong to hold a long-term bullish view on Eurozone equities relative to the US. However, the coming two years should be kind to euro area stocks. The relative performance of European stocks compared to that of the US is predominantly a function of yields. BCA foresees higher yields over a 24-month period. Moreover, European equities are exceptionally cheap, which accentuates their appeal as a yield play. Tactical considerations indicate that a modest overweight in European stocks, not an aggressive one, is most appropriate for cyclical investors. European investment grade bonds are appealing in a European fixed-income portfolio. Feature Chart 1Europe's Underperformance Explained Over the past decade, Eurozone equities have massively underperformed US ones. The poor outcome generated by European bourses mimicked the fall in European profits against the US (Chart 1). Considering that the relative performance of euro area stocks stands at an all-time low, should investors begin to bet on Europe? The outlook for yields favors European stocks on a cyclical basis. However, the structural picture suggests that both Europe and the US must experience fundamental changes before European stocks can surpass their US counterparts on a long-term basis.  Structural Challenges Remain The case for overweighting European equities on a structural investment horizon (5 to 10 years) remains weak. Only some major changes in the European and US economies can alter the long-term headwinds facing Eurozone stocks. Table 1US Possesses The Favored Sectors Sectoral biases partly explain Europe’s inability to match the US’s profit potential. The US market over-represents high-margin and high return-on-equity businesses, such as technology and healthcare, while most Eurozone bourses have significant weightings in the structurally challenged financial, materials, and energy sectors (Table 1). This difference in sector representation also explains the larger buybacks witnessed in US markets compared to euro area ones, which further boosted the US’s relative EPS. Chart 2Japan Never Recovered The performance of Japanese equities over the past three decades provides another cautionary tale for European stocks. Despite a substantial underperformance in the 1990s, Japanese equities never meaningfully recovered in the 2000s and ended up falling further behind the US over the past 12 years (Chart 2). A powerful liquidity trap and a 23% decline in the Japanese population compared to that of the US seriously hampered the ability of Japanese firms to generate stronger relative cash flows. This challenging profit picture meant that no matter how low JGB rates fell in comparison to the US, Japanese multiples never benefited from a significant re-rerating.  The Eurozone suffers from similar ills to that of Japan, which warns that the latter constitutes a valid template for European assets. Europe’s population is expected to decline by 16% relative to that of the US over the coming three decades, which will hurt sales and capex in Europe. Moreover, despite low interest rates, private credit demand is weak, which limits the region’s economic vigor. Most concerning, Europe’s capital stock as a share of GDP is substantial, especially in the periphery (Chart 3). Such an observation indicates that there is a high probability that previously misallocated capital is burdening the euro area. This misallocation will continue to hurt economic activity, because it encumbers demand via weak capex and also harms productivity. A DuPont decomposition of RoE reveals how Europe’s economic malaise affects corporate profitability (Chart 4). The Eurozone’s excessively large capital stocks means that its asset turnover is inferior to that of the US, which corroborates the notion that capital is misallocated. Moreover, the euro area’s low profit margins reflect more than its sectoral composition. Greater economic rigidities as well as lower market power and concentration in Europe hurt profitability (even if it limits inequalities compared to the US). Finally, the corporate sector is deleveraging, which is a consequence of a liquidity trap and poor trend growth, causing the ratio of RoE to RoA to decline relative to the US. Chart 3Too Much Capital Chart 4DuPont De No Good To reverse the structural outperformance of US equities relative to the Eurozone, Europe’s secular profitability underperformance must end. We will look for the following factors to stop this decline, which we will explore in further detail over time: European reforms. Europe will remain disadvantaged until its excess capital stock is written off. This process is complex and it will require greater fiscal integration as well as greater reforms to promote competition and to decrease labor market as well as service sector rigidities. More Innovation. Despite a strong patent record in economies such as Germany, Europe lags behind the US in the creation of leading innovative companies. Europe’s industrial and consumer discretionary sectors could prove beneficiaries of the green revolution taking place around the world, but it is still too early to tell. Chart 5Market Power Helps The US An ossification of the US economy. Europe could also begin to outperform, because the US might lose its edge. Economic populism is rife in the US, fueled by growing discontent with economic inequalities. As a result, government involvement in the economy as well as regulatory efforts could increase significantly. While a push to redistribute income toward the middle class would alleviate inequalities, it would hurt profitability and cause US RoE to decline toward European levels (Chart 5). Bottom Line: The secular underperformance of Eurozone equities reflects their inability to generate as much profits as US ones. Beyond sector biases, Europe’s demographic hurdles and its deeper problem with secular stagnation remain its key handicaps. For now, there is no solid case to bet on a major change in these trends, which only European reforms or problems in the US can undo. But A Cyclical Opportunity Exists Despite the challenging structural environment for European equities, the cyclical outlook (24 months) is attractive. Even in Japan, multi-year episodes of outperformance punctuated a decades-long underperformance relative to the US or the MSCI all-country world index. In the case of the Eurozone, this upbeat view rests on BCA Research expectations of higher global yields. The performance of Europe’s equities relative to the US correlates closely with the level of US yields (Chart 6). The sectoral footprint of both bourses is an important driver of this correlation. The US overweighs growth and defensive stocks, which account for 49% and 23% of its capitalization, respectively. Meanwhile, the euro area over-represents value stocks and deep cyclicals, which account for 55% and 26% of its market, respectively. Historically, global value stocks beat growth equities when yields are rising (Chart 7).  Chart 6A Yield Story Chart 7What Value Likes The outperformance of value stocks when yields rise is multifaceted. Deep cyclicals, such as industrials, materials, financials and energy, constitute a larger share of value benchmark than growth ones. Consequently, when yields increase because the global business cycle experiences an upswing, the earnings of value stocks accelerate compared to those of growth stocks (Chart 7, bottom panel). The positive impact of yields on the value versus growth split is also more direct. Higher yields, especially if they accompany a steeper yield curve, boost the profitability of financials. Meanwhile, mounting yields increase the discount factor applied to the long-term deferred cash flows that contribute a large proportion of the intrinsic value of growth stocks. Higher yields also support the relative performance of Eurozone stocks via the evolution of the expected growth rates of their long-term earnings. As Chart 8 illustrates, upgrades to sell-side estimates of the long-term growth rate of European EPS relative to the US coincide with a steeper US yield curve slope and rising 5-year/5-year forward Treasury yields. These relationships exist because European economic activity and sectoral representation are more cyclical than that of the US.  Eurozone equities look like a particularly cheap bet on higher yields over the coming 18 to 24 months. Sentiment toward European assets remains depressed compared to the US. Even on an equal-weighted basis, the discount of the expected long-term growth rate of euro area EPS relative to the US is exceptionally wide (Chart 9, top panel). True, the sustainable growth rate (SGR) of earnings is a function of the return on equity and the dividend payout ratio. Nonetheless, despite the fact that the euro area low RoE forces the European SGR down, Eurozone stocks embed a long-term growth rate that is 47% too low vis-à-vis the US. Other metrics underscore the cheapness of European equities relative to the US. Our Mechanical Valuation Indicator, which is sector neutral, stands at a 1-sigma discount in favor of the Eurozone (Chart 9, bottom panel). Chart 8EPS Growth and The Yield Structure Chart 9Europe Is Cheap Ultimately, Europe’s relative expected growth and valuations are particularly depressed, because domestic activity lags behind that of the US by a significant margin. As the vaccination campaign advances and the economy reopens later in the quarter, the Eurozone’s service sector will catch up and the earnings growth discount will dissipate (Chart 10). Moreover, regardless of its recent dynamism, even the European industrial sector has room to catch up to the US. Our Swedish Economic Diffusion Index captures the general strength in Swedish economic activity, which foretells a further increase in both the euro area Manufacturing PMI and equities relative to the US (Chart 11). Chart 10Stronger Services Will Help Chart 11Listen To Sweden Bottom Line: BCA’s expectations that global yields will rise over the coming 24 months are consistent with Eurozone equities outperforming US ones over this period, even if the long-term outlook remains challenging for Europe. European equities are much more pro-cyclical than US ones, which is reified by their sector and value biases. Moreover, euro area equities currently embed a particularly large discount to their US counterpart, which increases their attractiveness as a play on rising bond yields. The Right Entry Point? Strategy and forecasts are two different things. BCA strongly believes that yields will rise over the coming two years; however, a large overweight in Eurozone equities is a risky bet at the current juncture. Instead, we recommend investors opt for a modest overweight. Short-term traders should stay clear of this market for now. The reason for this cautiousness is that yields are very vulnerable to a temporary near-term pullback because: Chart 12A Countertrend Bond Rally? Technicals point to a counter-trend bounce in bond prices. Our BCA Composite Technical Indicator is massively oversold, our Composite Sentiment Indicator is extremely depressed, and speculators are aggressively shorting T-Bonds (Chart 12). The recent bond market behavior is puzzling. Despite March’s blockbuster non-farm payroll data and Manufacturing, as well as Services ISM surveys, yields are softening. Not even the announcement of the Biden administration’s $2.3 trillion American Jobs Plan could increase yields in recent weeks. This price action confirms that bonds are oversold and that, until the recent price decline is digested, the threshold to push yields higher has risen meaningfully. Equities are at risk of a pullback. Euphoria is prevalent, which increases the odds of corrective action in equities. Our BCA Equity Capitulation Index stands at a 45-year high (Chart 13) and our US Equity Strategy team’s Risk Appetite Index is at its highest levels since 2007, both of which suggest that complacency is rife. Moreover, the put/call ratio has collapsed to 0.45, which shows the carefree attitude of traders. Yields will decline if stock prices correct. EM equities are underperforming US stocks. EM benchmarks are more sensitive to marginal changes in the global growth outlook. For now, the risk is that growth disappoints lofty expectations. Since 2014, periods of relative weakness in EM bourses precede declines in Treasury yields (Chart 14). Authorities are trying to limit credit growth in China. As we argued two weeks ago, Beijing is aiming to slow credit growth to prevent systemic vulnerabilities from developing. This process is fraught with risks and is likely to result in a deceleration in China’s economy. While Europe and most emerging markets remained mired in a health crisis, China will be a source of temporary downside for global economic activity. The recent announcement that the PBoC asked Chinese banks to limit new loans confirms this assessment. Chart 13Euphoria! Chart 14EM Stocks Are Telling Us Something Bottom Line: For now, investors with a cyclical horizon (two years) should only keep a modest overweight position in Eurozone equities because the near-term outlook for yields points to some temporary downside. Not allocating the full allowable capital budget to Europe will allow investors to upgrade their overweight after the near-term downside in yields has passed. Investors may also consider implementing some hedges. Our foreign exchange strategist recommends a short EUR/JPY position as a form of portfolio protection. Keeping some cash in yen to deploy later in Europe mimics this advice. Short-term traders should stay clear of Europe as long as bond markets have not digested their oversold condition. Market Focus: Investment Grade Corporates and the ECB The ECB’s minutes highlight that investment grade corporate bonds are attractive within European fixed-income portfolios. The recently released ECB minutes revealed that higher real rates do not overly concern the Governing Council, because they reflect an improving global economic outlook and not an eventual policy tightening. Moreover, the GC does not want to give the impression it will engage in yield control, yet the pace of purchases under the Pandemic Emergency Purchase Programme (PEPP) will remain accelerated and flexible until June, at a minimum. The ECB will not derail the supportive environment for economic activity anytime soon. Meanwhile, as we have argued in past reports, fiscal policy in Europe will also stay relaxed for the time being. Thus, the Eurozone’s policy environment remains supportive for credit spreads, especially since the default cycle has been muted. However, do corporate bonds already fully price in this positive backdrop? According to the 12-month breakeven spread, European credit spreads can compress further. The breakeven spread is the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It is approximated by dividing the OAS of a bond (or an index) by its duration. The breakeven spread is then compared to its own history, by observing the percentage of time that it has been lower in the past.1  Chart 15Some Value Left European credit spreads have tightened 160 bps since March last year and are already below their pre-Covid level (Chart 15). However, the 12-month breakeven spread has been tighter 18% of the time since 1999. In other words, higher quality corporate bonds in Europe have room to see further spread compression, since policy will remain relaxed for a long time. This is especially true in the Aa-rated credit tier, where the breakeven spread has been more expensive 35% of the time (not shown). Meanwhile, US breakeven spreads for IG corporate bonds are in their 2nd percentile and policy will tighten sooner than in Europe. Therefore, bond investors with a European-only mandate are not forced to step down the quality ladder as aggressively as those in the US do. Table 2Norway, France And Italy Stand Out Table 2 provides the same analysis at the country level. Taking into consideration the average credit rating of each countries’ investment grade bonds, we find that Norwegian, French, and Italian spreads have the most value left. Interestingly, the ECB’s purchases of Italian and French paper is currently deviating widely from its capital keys, which should place downward pressure on credit spreads in these jurisdictions. Bottom Line: There is still value left in European investment grade corporate bonds, unlike in the US, where valuations are extremely expensive and a decrease in quality is warranted. For now, such a move is uncalled for in Europe, especially since the value in its high-yield index is concentrated in its riskiest credit tiers. At the country level, investors should favor Norwegian, French, and Italian investment grade corporate bonds.   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com   Jeremie Peloso, Senior Analyst JeremieP@bcaresearch.com   Footnotes 1We find this valuation tool superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.   Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades

Highlights The latest major economic releases have been solidly positive, … : The manufacturing ISM hit a 37-year high and the services ISM made a new all-time high in its 24-year history, while the March employment report was quite strong. … but they have fallen within the wide distribution of Goldilocks economic and market outcomes, … : The pace of vaccinations is limiting the potential of a negative pandemic surprise and the Fed continues to stick to its easier-for-longer messaging. … though we are watching the potential to drift into the too-hot right tail: Although the labor market is awash in excess capacity, both ISM surveys are telling a pro-inflation story replete with bottlenecks, shortages and suppliers willing to exploit their advantages. Earnings season will shed some light on how long the good times can be sustained: First quarter earnings releases begin this week with the SIFI banks. We will look to management commentary for insight into how corporate earnings are likely to stack up against expectations and how long we might be able to stick with our risk-friendly positioning. Feature When the COVID-19 pandemic reached the US last spring, our view turned on the outcome of the battle between policy makers and the virus. We were optimistic that the economy could escape long-term damage and that risk assets would be able to come back from their vicious February-March declines because we expected that policy makers would do what it took to build a bridge across the pandemic crater. Once the Democrats captured the White House and a majority in both houses of Congress, the policymakers-versus-the-virus outcome was settled, as the Biden-Pelosi-Schumer triumvirate ensured that fiscal policy would join monetary policy in erring to the side of providing too much support to the economy. The investment narrative now has shifted to whether or not policy makers have overdone it. It is possible to have too much of a good thing and excessive stimulus could cause the economy to overheat, hastening the end of the just-right Goldilocks combination of strong growth and easy monetary policy. It is also possible that the pandemic could still spring a nasty surprise on the United States, bringing about a growth disappointment despite indulgent policy, but the probability of a bad public-health outcome appears to shrink every week that the rapid vaccination clip is maintained. Our new framework is Goldilocks and the two tails (Figure 1), in which the probability of a just-right outcome that keeps the strong-growth, easy-policy beat going is considerably larger than unanticipated slowing (the too-cold left tail) or overheating (the too-hot right tail). This week, we review vaccine progress, consumer loan delinquencies and key economic releases to assess where in our stylized distribution the economy is likely to fall. Figure 1Goldilocks And The Two Tails The Left Tail We have viewed widespread vaccinations as the best way to inoculate the economy against a left-tail outcome. The more quickly herd immunity can be achieved via vaccinations, the less likely that growth will fall short of market expectations. We are impressed with the ground the US has made up after stumbling out of the gate; vaccine production has ramped up well beyond expectations and a mix of public and private injection sites are getting doses delivered. Assuming that new virus-resistant variants do not emerge, it looks as if the US is sure to meet the goal of inoculating a critical mass of the adult population well before September 30th (Chart 1). Chart 1Off And Running A self-reinforcing wave of defaults and bankruptcies would have been at the center of any worst-case economic and market scenarios. The Fed was keenly aware of the threat and preventing avoidable bankruptcies was an explicit monetary policy aim. Zero interest rates, massive asset purchases and new emergency measures like the Primary and Secondary Corporate Credit Facilities paved the way for record corporate bond issuance, eradicating the threat of bankruptcy for many viable businesses that were severely strained by the pandemic. Generous fiscal policy more directly buoyed household borrowers, but Powell and company had an eye out for them as well, highlighting the goal of : “just … keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months.”1 Personal loan performance has therefore been an important indicator for tracking the course of the recovery and policy makers’ success in promoting it. We have been monitoring 60-day delinquency rates across the four main consumer loan categories (90-day rates for credit cards) ever since TransUnion began publishing them on a monthly basis last spring. They have been a good barometer (with a lag) of the flow of transfer payments from the federal government to households. The $1,200 economic impact payments for adults with annual earnings below $75,000 were distributed in March and April, while the $600 weekly federal unemployment insurance (UI) benefit supplement was available from late March until the end of July, and delinquency rates steadily declined from March through August in every category but autos (Chart 2, top panel). Chart 260-Day Delinquency Rates Had Stopped Falling … Chart 3… But The Leading 30-Day Delinquencies Are Headed Lower After the UI supplements stopped flowing in the second half of the year, 60-day delinquencies began creeping up in every category but mortgages (Chart 2, third panel). A new round of $600 checks that were distributed in January, along with the resumption of federal UI benefit supplement payments at a rate of $300 per week, helped the February numbers and March’s $1,400 checks will extend the positive turn. The 30-day delinquency rates show the same pattern, but with bigger declines in February (Chart 3). 30-day delinquency rates lead 60- and 90-day rates and their positive trend will surely be enhanced by the latest round of direct payments and the gathering hiring momentum on display in the March employment report. Along with the success of the vaccination rollout, consumer loan performance suggests that the probability of left-hand tail outcomes is narrowing. Robust ISM Surveys And The Specter Of Cost-Push Inflation The ISM manufacturing and services PMI surveys stand out amid the welter of economic data that researchers and investors have to navigate. They are issued monthly with virtually no lag and provide a reliable read on the economy’s direction. Given that stocks tend to perform well when the economy performs well, they also provide information about the future direction of the stock market (Chart 4) and offer a first-cut guide to asset allocation. Chart 4A Strong Economy Is Good For Equity Returns The March composite releases were quite strong, with the manufacturing survey hitting a 37-year high and the services survey reaching the highest level in its 24-year history. The manufacturing survey was strong across the board, with new orders and order backlogs at or near extended highs (Chart 5, fourth panel) and the production and employment indexes (Chart 5, second and third panels) pointing to broad pickups. Unfortunately, the prices paid and supplier performance indexes (Chart 5, bottom panel) hinted that upward price pressures and supply bottlenecks have taken hold across broad swaths of the economy. Those components, and the accompanying comments from survey respondents, suggest that upward inflation pressures are building. The ISM services PMI survey closely resembled its manufacturing counterpart. New orders (Chart 6, fourth panel) and business activity (Chart 6, second panel) were very strong, though not as large a share of services employers are looking to hire (Chart 6, third panel). The share of respondents facing higher prices has broken out (Chart 6, fifth panel) and lengthening supplier delivery times are prevalent. The services sector has more slack than the manufacturing sector, but it is not immune from inflation pressure. Chart 5The Manufacturing PMI Looks A Lot Like ... Chart 6... Its Services Counterpart It is important to remember that the PMI surveys are diffusion indexes that capture share rather than magnitude. The record and near-record readings don’t mean that respondents’ businesses are growing at their most rapid rate in decades; they mean that the share of respondents who report quickening growth is at record/near-record levels. The same goes for the near-record prices paid readings; they don’t reflect that prices are rising at close-to-record rates, they reflect that an unusually large proportion of companies report increasing prices. The diffusion of upward price pressures as reported in the surveys has had a solid record of leading year-on-year core CPI increases and testifies to the economy’s potential to overheat (Chart 7). Cost-push inflation pressures could derail the strong-growth/easy-policy backdrop. Chart 7Inflation Pressures Have Begun To Stir Bottom Line: The ISM PMI surveys reinforce the idea that the probability of a left-hand tail outcome is modest and shrinking, but they suggest that right-tail overheating is a valid concern. Labor Market Firmly In Goldilocks Territory Chart 8The Labor Market Still Has A Lot Of Slack Net payroll gains in the March employment report comfortably surpassed expectations, while January’s and February’s estimates were also revised higher. The employment figures added to the run of positive surprises in key economic data series that suggest that growth in 2021 and 2022 will run well above its long-term potential. Despite the gains, however, employment remains far below its pre-pandemic peak (Chart 8, top panel) and the spaces that were hardest hit by the pandemic, like restaurants and hospitality, are not operating at anything close to full capacity. With labor force participation sharply reduced from its pre-pandemic level (Chart 8, bottom panel), the labor market is a long way from being tight. With all the excess capacity in the labor market, wage growth has been well behaved. Neither of the main wage series is growing at a rate that would give rise to inflation concerns. Average hourly earnings are up a lot year-over-year (Chart 9, top panel) because of a 5% month-over-month surge last April, but they have been running in place for the last three months and face much tougher comparisons beginning next month. The employment cost index has been rising at a rate well below its 2019 peak (Chart 9, bottom panel) that accompanied half-century lows in the unemployment rate. Chart 9Wage Growth Is Not Yet A Reason For Concern With considerable ground to make up to get back to its pre-pandemic state, the labor market appears to have plenty of room to run before it pulls the overall economy into overheating territory. The combination of ample slack and a strong backlog of labor demand (Chart 10) hints at a best-of-both-worlds/Goldilocks scenario. As long as it remains in place, the labor market is likely to be a positive economic catalyst, promoting robust hiring activity without setting off a self-reinforcing wage-price dynamic that would prod the Fed to cut off monetary accommodation in an abrupt way that would disrupt financial markets. Chart 10There's Still A Lot Of Demand For Workers Investment Implications We stand by our base case that the Goldilocks backdrop of solid growth and ample monetary accommodation will remain in place at least into early 2022. That backdrop precludes the possibility of a recession and therefore argues for risk-friendly investment strategy. Stocks rarely experience significant reversals outside of recessions and spread product reliably generates positive excess returns over Treasuries and cash. Multi-asset investors should remain at least equal weight equity and credit while holding fixed income duration below benchmark levels. We have a high degree of conviction that the economy will avoid a downside surprise in the next twelve months, thanks to the success of the vaccination effort and measures undertaken to limit defaults by households and businesses. We are less sure that the economy will be able to avoid overheating. A rapid rise in consumer prices to levels that would unsettle markets and force the Fed into tightening monetary policy sooner than expected is not our base case but it cannot be ruled out. We will be perusing the data for any advance indications that inflation could be gaining a foothold while also carefully observing what we see in our day-to-day experience. We will also be listening eagerly to what corporate management teams have to say over the next three to four weeks when they report their first-quarter earnings and offer their impressions of the second quarter and the full year.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Interview conducted May 13, 2020 and broadcast May 17. Full Transcript: Fed Chair Jerome Powell's 60 Minutes interview on economic recovery from the coronavirus pandemic - CBS New.

Overweight We have been overweight the niche (0.33% of the S&P 500) airlines sector going into the pandemic, and while it has been slow to recover, there is little doubt that soon airline stocks will reclaim their pre-COVID-19 altitude. The top panel of the chart on the right highlights that travelling is making a comeback as a larger and larger proportion of the world population is becoming inoculated. Consequently, air travel is springing to life. Another services industry that COVID-19 wrecked also confirms that the path of least resistance is higher for airlines: indoor dining is en route to rebound to pre-pandemic levels (middle panel). Finally, business and consumer travelling is slated to make a huge comeback following months of “staycations”. Consumers and businesses alike have amassed significant excess savings and stand ready to draw them down when the opportunity arises, likely some time after Memorial Day. This will further underpin the recovery in airlines and other savaged services stocks. Bottom Line: Stay overweight the S&P airlines index that will be gaining altitude as fiscal checks trickle down through the economy at a time when the US at large reaches herd immunity. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. ​​​​​​​

Highlights Continued upgrades to global economic growth – most recently by the IMF this week –will support higher natgas prices.  In our estimation, gas for delivery at Henry Hub, LA, in the coming withdrawal season (November – March) is undervalued at current levels at ~ $2.90/MMBtu. Inventory demand will remain strong during the current April-October injection season, following the blast of colder-than-normal weather in 1Q21 that pulled inventories lower in the US, Europe and Northeast Asia. The odds the US will succeed in halting completion of the final leg of the Russian Nord Stream 2 natural gas pipeline into Germany are higher than the consensus expectation.  Our odds the pipeline will not be completed this year stand at 50%, which translates into higher upside risk for natural gas prices.  We are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close.  The probability of Nord Stream 2 cancellation is underpriced, which means European TTF and Asian JKM prices will have to move higher to attract LNG cargoes next winter from the US, if the pipeline is cancelled (Chart of the Week). Feature As major forecasting agencies continue to upgrade global growth prospects, expectations for industrial-commodity demand – energy, bulks, and base metals – also are moving higher. This week, the IMF raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021.1 This upgrade follows a similar move by the OECD last month.2 In the US, the EIA is expecting industrial demand for natural gas to rise 1.35 Bcf/d this year to 23.9 Bcf/d; versus 2019 levels, industrial demand will be 0.84 Bcf/d higher in 2021. For 2022, industrial demand is expected to be 24.2 Bcf/d. US industrial demand likely will recover faster than the EU's, given the expectation of a stronger recovery on the back of massive fiscal and monetary stimulus. Overall natgas demand in the US likely will move lower this year, given higher natgas prices expected this year and next will incentivize electricity generators to switch to coal at the margin, according to the EIA. Total demand is expected to be 82.9 Bcf/d in the US this year vs. 83.3 Bcf/d last year, owing to lower generator demand. Pipeline-quality gas output in the US – known as dry gas, since its liquids have been removed for other uses – is expected to average 91.4 Bcf/d this year, essentially unchanged. Lower consumption by the generators and flat production will allow US gas inventories to return to their five-year average levels of 3.7 Tcf by the end of October, in the EIA's estimation (Chart 2). Chart of the WeekUS-Russia Geopolitical Risk Underpriced Chart 2US Natgas Inventories Return To Five-Year Average US Liquified Natural Gas (LNG) exports are likely to expand, as Asian and European demand grows (Chart 3). Prior to the boost in US LNG demand from colder weather, exports set monthly records of 9.4 Bcf/d and 9.8 Bcf/d in November and December of last year, respectively, with Asia accounting for the largest share of exports (Chart 4). This also marked the first time LNG exports exceeded US pipeline exports to Mexico and Canada. The EIA is forecasting US LNG exports will be 8.5 bcf/d and 9.2 Bcf/d this year and next, versus pipeline exports of 8.8 Bcf/d and 8.9 Bcf/d in 2021 and 2022, respectively. Chart 3US LNG Exports Continue Growing Chart 4US LNG Exports Set Records In November And December 2020 US LNG exports – and export potential given the size of the resource base at just over 500 Tcf – now are of a sufficient magnitude to be a formidable force in global markets, particularly in Europe. This puts it in direct conflict with Russia, which has targeted Europe as a key market for its pipeline natural gas exports. US-Russia Standoff Looming Over Nord Stream 2 Given the size and distribution of global oil and gas production and consumption, it comes as no surprise national interests can, at times, become as important to pricing these commodities as supply-demand fundamentals. This is particularly true in oil, and increasingly is becoming the case in natural gas. That the same dramatis personae – the US and Russia – should feature in geopolitical contests in oil and gas markets also should not come as a surprise. In an attempt to circumvent transporting its natural gas through Ukraine, Russia is building a 1,230 km underwater pipeline from Narva Bay in the Kingisepp district of the Leningrad region of Russia to Lubmin, near Greifswald, in Germany (Map 1). The Biden administration, like the Trump administration and US Congress, is officially attempting to halt the final leg of the pipeline from being built, although Biden has not yet put America’s full weight into stopping it. Biden claims it will be up to the Europeans to decide what to do. At the same time, any major Russian or Russian-backed military operation in Ukraine could trigger an American action to halt the pipeline in retaliation. Map 1Nord Stream 2 Route In our estimation, there is a 50% chance that the Nord Stream 2 natural gas pipeline will not be completed this year or go into operation as planned given substantial geopolitical risks. The $11 billion pipeline would connect Russia directly to Germany with a capacity of about 55 billion cubic meters, which, combined with the existing Nord Stream One pipeline, would equal 110 BCM in offshore capacity, or 55% of Russia's natural gas exports to Europe in 2019. The pipeline’s construction is 94% complete, with the Russian ship Akademik Cherskiy entering Danish waters in late March to begin laying pipes to finish the final 138-kilometer stretch, according to Reuters. The pipeline could be finished in early August at the pace of 1 kilometer per day.3 The Russian and German governments are speeding up the project to finish it before US-Russia tensions, or the German elections in September, interrupt the construction process again. It is not too late for the US to try to halt the pipeline through sanctions. But for the Americans to succeed, the Biden administration would have to make an aggressive effort. Notably the Biden administration took office with a desire to sharpen US policy toward Russia.4 While Biden seeks Russian engagement on arms reduction treaties and the Iranian nuclear negotiations, he mainly aims to counter Russia, expand sanctions, provide weapons to Ukraine, and promote democracy in Russia’s sphere of influence. The result will almost inevitably be a new US-Russia confrontation, which is already taking shape over Russia’s buildup of troops on the border with Ukraine, where US and Russian meddling could cause civil war to reignite (Map 2). Map 2Russia’s Military Tensions With The West Escalate In Wake Of Biden’s Election And Ukraine’s Renewed Bid To Join NATO Tensions in Ukraine are directly tied to US military cooperation with Ukraine and any possibility that Ukraine will join the NATO military alliance, a red line for Putin. Nord Stream 2 is Russia’s way of bypassing Ukraine but a new US-Russia conflict, especially a Russian attack on Ukraine, would halt the pipeline. The pipeline’s completion would improve Russo-German strategic relations, undercut US liquefied natural gas exports to Germany and the EU, and reduce the US’s and eastern Europe’s leverage over Russia (and Germany). Biden says his administration is planning to impose new sanctions on firms that oversee, construct, or insure the pipeline, and such sanctions are required under American law.5 Yet Biden also wants a strong alliance with Germany, which favors the pipeline and does not want to escalate the conflict with Russia. The American laws against Nord Stream have big loopholes and give the president discretion regarding the use of sanctions, which means Biden would have to make a deliberate decision to override Germany and impose maximum sanctions if he truly wanted to halt construction.6 This would most likely occur if Russia committed a major new act of aggression in Ukraine or against other European democracies. The German policy, under the current ruling coalition led by Chancellor Angela Merkel’s Christian Democratic Union, is to finish the pipeline despite Russia’s conflicts with the West and political repression at home. Russia provides more than a third of Germany’s natural gas imports and this pipeline would bypass eastern Europe’s pipeline network and thus secure Germany’s (and Austria’s and the EU’s) natural gas supply whenever Russia cuts off the flow to Ukraine (through which roughly 40% of Russian natural gas still must pass to reach Europe). Germany's Election And Natgas Politics Germany wants to use natural gas as a bridge while it phases out nuclear energy and coal. Natural gas has grown 2.2 percentage points as a share of Germany’s total energy mix since the Fukushima disaster of 2011, and renewable energy has grown 7.7ppt, while coal has fallen 7.3ppt and nuclear has fallen 2.5ppt (Chart 5). The German federal election on September 26 complicates matters because Merkel and the Christian Democrats are likely to underperform their opinion polls and could even fall from power. They do not want to suffer a major foreign policy humiliation at the hands of the Americans or a strategic crisis with Russia right before the election. They will insist that Biden leave the pipeline alone and will offer other forms of cooperation against Russia in compensation. Therefore, the current German government could push through the pipeline and complete the project even in the face of US objections. But this outcome is not guaranteed. The German Greens are likely to gain influence in the Bundestag after the elections and could even lead the German government for the first time – and they are opposed to a new fossil fuel pipeline that increases Russia’s influence. Chart 5Germany Sees Nord Stream 2 Gas As Bridge To Low-Carbon Economy Hence there is a fair chance that the pipeline does not become operational: either Americans halt it out of strategic interest, or the German Greens halt it out of environmental and strategic interest, or both. True, there is a roughly equal chance that Merkel’s policy status quo survives in Germany, which would result in an operational pipeline. The best case for Germany might be that the current government completes the pipeline physically but the next government has optionality on whether to make it operational. But 50/50 odds of cancellation is a much higher risk than the consensus holds. The Russian policy is to finish Nord Stream 2 while also making an aggressive military stance against the West’s and NATO’s influence in Ukraine. This would expand Russian commodity and energy exports and undercut Ukraine’s natgas transit income. It would also increase Russian leverage over Germany – and it would divide Germany from the eastern Europeans and Americans. A preemptive American intervention would elicit Russian retaliation. The Russians could respond in the strategic sphere or the economic sphere. Economically they could react by cutting off natural gas to Europe, but that would undermine their diplomatic goals, so they would more likely respond by increasing production of natural gas or crude oil to steal American market share. In any scenario Russian retaliation would likely cause global price volatility in one or more energy markets, in addition to whatever volatility is induced by the cancellation of Nord Stream 2 itself. US-Russia tensions are likely to escalate but only Ukraine and Nord Stream 2, or the separate Iranian negotiations, have a direct impact on global energy supply. If Germany goes forward with the pipeline, then Russia would need to be countered by other means. The Americans, not the Germans, would provide these “other means,” such as military support to ensure the integrity of Ukraine and other nations’ borders. The Russians may gain a victory for their energy export strategy but they will never compromise on Ukraine and they will still need to focus on the broader global shift to renewable energy, which threatens their economic model and hence ultimately their regime stability. So, the risk of a market-moving US-Russia conflict can be delayed but probably not prevented (Chart 6). Chart 6US-Russia Conflit Likely Bottom Line: The Nord Stream 2 pipeline is not guaranteed to be completed this year as planned. The US is more likely to force a halt to the Nord Stream 2 pipeline than the consensus holds, especially if Russia attacks Ukraine. If the US fails to do so, then the German election will become the next signpost for whether the pipeline will become operational. If the Americans halt the pipeline, then US-Russian conflict either already erupted or will occur sooner rather than later and will likely impact global oil or natural gas prices. Investment Implications Our subjective assessment of 50% odds the US will succeed in halting completion of the final leg of Nord Stream 2 are higher than the consensus expectation. This translates directly into higher upside risk for natural gas prices in the US and Europe later this year and next. Given our view, we are getting long 1Q22 calls on CME/NYMEX Henry Hub-delivered natgas futures struck at $3.50/MMBtu vs. short 1Q22 $3.75/MMBtu calls at tonight's close. The probability of Nord Stream 2 cancellation is underpriced, which means the odds of higher prices in the LNG market are underpriced (Chart 7). The immediate implication of our view is European TTF prices will have to move higher to attract LNG cargoes next winter from the US, if the Nord Stream 2 pipeline's final leg is cancelled. This also would tighten the Asian markets, causing the JKM to move higher as well (Chart 8). Any indication of colder-than-normal weather in the US, Europe or Asian markets would mean a sharper move higher. Chart 7Natgas Tails Are Too Narrow For Next Winter Chart 8Nord Stream 2 Cancellation Would Boost JKM Prices   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Commodities Round-Up Energy: Bullish The US and Iran began indirect talks earlier this week in Vienna aimed at restoring the Joint Comprehensive Plan of Action (JCPOA), otherwise known as the "Iran nuclear deal." All of the other parties of the deal – Britain, China, France, Germany and Russia – are in favor of restoring the deal. BCA Research believes this is most likely to occur prior to the inauguration of a new president who is expected to be a hardliner willing to escalate Iran’s demands. US President Biden can unilaterally ease sanctions and bring the US into compliance with the deal, and Iran could then reciprocate. If a deal is not reached by August it could take years to resolve US-Iran tensions. China could offer to cooperate on sanctions and help to broker negotiations following the signing of its 25-year trade deal with Iran last week. Russia likely would demand the US not pressure its allies to cancel the Nord Stream 2 deal, in return for its assistance in brokering a deal. Base Metals: Bullish Iron ore prices continue to be supported by record steel prices in China, trading at more than $173/MT earlier this week. Even though steel production reportedly is falling in the top steel-producer in China, Tangshan, as a result of anti-pollution measures, for iron ore remains stout. As we have previously noted, we use steel prices as a leading indicator for copper prices. We remain long Dec21 copper and will be looking for a sell-off to get long Sep21 copper vs. short Sep21 copper if the market trades below $4/lb on the CME/COMEX futures market (Chart 9). Precious Metals: Bullish Gold held support ~ $1,680/oz at the end of March, following an earlier test in the month. We remain long the yellow metal, despite coming close to being stopped out last week (Chart 10). The earlier sell-off appeared to be caused by a need to raise liquidity to us. We continue to expect the Fed to hold firm to its stated intent to wait for actual inflation to become manifest before raising rates, and, therefore, continue to expect real rates to weaken. This will be supportive of gold and commodities generally (Chart 10). Ags/Softs: Neutral Corn continues to be well supported above $5.50/bu, following last week's USDA report showing farmers intend to increase acreage planted to just over 91mm acres, which is less than 1% above last year's level. Chart 9 Chart 10       Footnotes 1     Please see the Fund's April 2021 forecast Managing Divergent Recoveries. 2     We noted last week these higher growth expectations generally are bullish for industrial commodities – energy, metals, and bulks.  Please see Fundamentals Support Oil, Bulks, And Metals, which we published 1 April 2021.  It is available at ces.bcaresearch.com. 3    For the rate of construction see Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Eurasia Daily Monitor 18: 17 (February 1, 2021), Jamestown Foundation, jamestown.org. For the current status, see Robin Emmott, “At NATO, Blinken warns Germany over Nord Stream 2 pipeline,” Reuters, March 23, 2021, reuters.com. 4    The Democratic Party blames Russia for what it sees as a campaign to undermine the democratic West and recreate the Soviet sphere of influence. See for example the 2008 invasion of Georgia, the failure of the Obama administration’s 2009-11 diplomatic “reset,” the Edward Snowden affair, the seizure of Crimea and civil war in Ukraine, the survival of Syria’s dictator, and Russian interference in US elections in 2016 and 2020. 5    The Countering Russian Influence in Europe and Eurasia Act of 2017, and the Protecting Europe’s Energy Security Act of 2019/2020, contain provisions requiring sanctions on firms that have contributed in any way a minimum of $1 million to the project, or provide pipe-laying services or insurance. There are exceptions for services provided by the governments of the EU member states, Norway, Switzerland, or the UK. The president has discretion over the implementation of sanctions as usual. 6    The German state of Mecklenburg-Vorpommern is creating a shell foundation to enable the completion of the pipeline. It can shield companies from American sanctions aimed at private companies, not sovereigns.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

We nearly fully captured the economic reopening theme through our long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade. As a brief summary, we first initiated this trade in the September 8th, 2020 Strategy Report, and subsequently closed it earlier this year for a gain of 21.5% via a rolling stop trigger, until we reopened it once again on February 3. Fast-forward to today, and this pair trade has vaulted another 25.5% since the second inception. Now that the US equity market is euphoric on the back of stimulus news and more importantly given that the bond market is no longer responsive having already priced in four Fed hikes by the end of 2023, we opt to re-introduce a 5% rolling stop as a risk management tool in order to protect handsome profits. Bottom Line: Institute a 5% rolling stop in the long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade today. ​​​​​​​