Energy

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

  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  

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

Special Report

Dear client, Next week, in lieu of our weekly report, I will be hosting a webcast on Tuesday, March 30 at 9:00 am HKT and Tuesday, March 30 at 10:00 am EDT. In the webcast, I will share our outlook on China’s post-pandemic economic and policy dynamics. Best regards, Jing Sima, China Strategist   Highlights China is aiming for a massive adoption of new energy vehicles (NEVs) to help achieve its 2030 peak carbon dioxide emissions target. The country’s NEV share of total vehicle sales will likely rise significantly to 40% in 2030, from only 5.4% in 2020. This will translate into a compound annual growth rate (CAGR) of 24%-25% in Chinese NEV sales in this decade. China will become increasingly competitive and important in the global NEV supply chain. The country will maintain its leading position in global electric vehicle battery production while reducing its dependence on imported auto chips.   The Chinese NEV production/sales boom will likely reduce the country’s crude oil consumption while increasing the country’s copper demand during 2021-2030. It will also impact more positively on nickel and lithium demand than on cobalt demand. The Chinese NEV stocks could be a good long-term investment, but we recommend waiting for a better entry point. Feature China's production and sales of new energy vehicles (NEVs) have ranked first in the world for six consecutive years. The country’s NEV sales quadrupled during 2015-2020, propelled by supporting policies such as significant amounts of subsidies to buyers.  We believe China will continue to be the leader in both global NEV sales and production this decade. The country’s NEV production and sales will get supercharged by continuing favorable polices and increasing consumers’ interest in NEVs. Many market-driven factors, including falling NEV prices, longer driving range per charge, rapid expansion in the NEV charging/battery-swapping network, as well as new functions including autonomous driving and more software applications-based services, will accelerate NEV adoption in China during 2021-2030. According to the country’s NEV development roadmap, the NEV share of total vehicle sales in China aims to rise to at least 40% in 2030, from only 5.4% in 2020. This will likely translate to a compound annual growth rate (CAGR) of 24%-25% in Chinese NEV sales in this decade. In 2030, the NEV sales in units could be eight to nine times its 2020 level, rising from 1.37 million units to 12-13 million units (Chart 1). Benefiting from the massive scale of the domestic NEV market, China will become increasingly competitive and important in the global NEV supply chain. The country will maintain its leading position in global electric vehicle battery production while reducing its dependence on imported auto chips. The Chinese NEV production/sales boom will help reduce transportation fuel consumption, leading to less carbon dioxide emissions (Chart 2).  Chart 1Chinese NEV Sales: A Supercharged Decade Ahead Chart 2China: Booming NEV Sales Reduce Oil Demand, Leading To Less CO2 Emissions In addition, the country’s copper demand will likely be increase due to booming NEV production during 2021-2030. Meanwhile, the impact will be more positive on nickel and lithium demand than on cobalt demand. Given such  significant growth ahead for the Chinese NEV market, we believe Chinese NEV-related stocks are a potential good buy, but we recommend waiting for a better entry point.   China’s NEV Market: A Supercharged Decade Chinese NEV market is entering a supercharged decade (Box 1). Box 1 Our Forecast Of China’s NEV Sales In 2030 Our estimates of China’s NEV sales in 2030 were derived from two assumptions. First, we assume the NEV share of total Chinese automobile sales in 2030 to be 40%. Based on last October’s report, “Technology Roadmap 2.0 for Energy-Saving and New Energy Vehicles,” published by the China Society of Automotive Engineers (China-SAE), the China-SAE projects that NEVs will account for at least 40% of total automobile sales in China in 2030. The China-SAE is under the supervision of the Ministry of Industry and Information Technology (MIIT). Second, as car ownership – the share of households owning one car – has already risen to over 50% in China, we assume the CAGR of the country’s automobile sales will slow to 1.5%-2.5% in the next decade from 3.4% in the past decade. Based on this assumption, China’s automobile annual sales will likely increase to 29-32 million units in 2030. What Are The Underlying Drivers For Such Significant Growth? First, the interest in buying a NEV is rapidly growing in China. In a September 2020 survey done by Roland Berger, 80% of surveyed potential car buyers in China were considering buying an electric vehicle as their next car, the highest among major economies (Chart 3). Last year, this surveyed number for China was only 60%. We believe this shift in buying intention will continue and will consequently translate into a boom in NEV sales during 2021-2030. NEV battery costs have decreased by nearly 90% since 2010 and will continue to fall (Chart 4). This will drive down average NEV selling prices as the battery in general accounts 40-45% of the total production cost of NEVs, thereby making them more appealing to buyers. Chart 3China: Rising Interest In NEV Purchases Chart 4NEV Battery Costs Will Continue To Fall The average driving range per charge for NEVs will continue to rise. The average driving mileage per charge in China has nearly doubled, from 190km in 2016 to 360km in 2019.1 Currently, a growing proportion of NEV vehicles on the market can even achieve a mileage of 600km and above with a single charge. This is already comparable to traditional gasoline-powered vehicles, which can also cover approximately 600km per fuel tank.  More models with a wide range of selling prices will soon be on the market. Last June, the cheapest electric car with a selling price of only RMB 28,800 (about US$4,000) was released into the Chinese market. Since then the sales of this model have quickly surpassed the Tesla Model 3 to become the hottest seller in China. This shows consumer enthusiasm for affordable NEVs. In the meantime, the success of Tesla electric cars in China demonstrated Chinese consumers’ strong interest in high-quality and expensive NEVs. Chart 5China Has The Most NEV Models In The World Chart 5 shows that China is the country with most electric vehicle models in the world. The number of available electric vehicle models  was 227 in China in 2019, significantly higher than all other individual countries. According to McKinsey, more than 250 new battery electric vehicle (BEV) and plug-in hybrid electric vehicle (PHEV) models will be introduced in the next two years alone. Most of these models will likely be sold in China, adding more purchase options for Chinese consumers. Faster charging time for EV batteries as well as expanding charging/battery-swapping networks are in the making. This will greatly reduce recharge waiting time for NEV drivers. Chart 6Chinese NEV Charging Infrastructure: The Rapid Expansion Will Continue Based on the data from the China Electric Vehicle Charging Infrastructure Promotion Alliance (EVCIPA), the number of both public and private charging poles has increased significantly from 2015 to 2020. In addition,  the number of private ones has already exceeded the number of public ones each year since 2017 (Chart 6). The rapid expansion in the country’s charging station network will continue. The number of total charging poles will likely rise from 1.7 million units to the government’s target of 5 million units in 2025. In addition, Wood Mackenzie last May forecasted this number could reach 9.8 million units in 2030. Roland Berger last September reported that the number of charging locations per 100 km of roadway was about 6.1 in China, significantly higher than 2.2 in Germany and 0.5 in the US (Chart 7). In terms of the number of charging stations per 1000 NEVs, China has also significantly exceeded other major automobile producing countries (Chart 8). Chart 7The Number Of Charging Locations Per 100 km Of Roadway Is Higher In China Than In Many Other Countries… Chart 8…The Same Is True Of The Number Of Charging Stations Per 1,000 NEVs Meanwhile, the Chinese government is also promoting an expansion of battery-swapping networks. The Chinese auto manufacturer Nio has been the leader in this area. The company currently has a network of 178 battery-swapping stations located in and between major cities such as Beijing and Shenzhen; by the end of the year, it plans to have 500 stations. The battery-swapping time for the Nio EV now can be as fast as 90 seconds, even faster than fueling up with gasoline. EVs will become increasingly equipped with functions such as autonomous driving and more software applications-based services. EVs will also become more integrated with intelligent and interactive networks. All these features will make EVs more attractive to automobile buyers.  Second, with the 2030 target for peak emissions, the Chinese authorities will likely continue to develop favorable polices for the domestic NEV sector. China’s key policy support tools for NEVs include tax reductions, direct subsidies to manufacturers, consumer subsidies, and mandated government procurements. In the past, China has provided immense support for NEVs by spending billions of dollars on direct subsidies to manufacturers2 and on consumer subsidy programs.3 In the future, the country’s policy focus will be on NEV charging/battery-swapping network development as well as on NEV-related technology research and investment. For example, since 2019, auto manufacturers have received credits for each NEV produced. The credits take into consideration factors such as the type of vehicle, as well as its maximum speed, energy consumption, weight, and range. This measure will encourage NEV automakers to put more emphasis on technological change. These government supports of technology and network development, coupled with strong interest in NEV purchases by domestic consumers, should offset the impact of the government’s reduced direct subsidies for NEV production and sales. China has reduced overall direct subsidies to both NEV manufacturers and consumers, and vehicles must meet minimum technical and performance criteria to qualify. In 2021, subsidies will be reduced by 20% on NEVs for personal use, and by 10% on NEVs for public transport, including buses and taxis, from their respective 2020 level. In addition, NEV subsidies and tax exemptions will expire at the end of 2022 and subsidies will be limited to 2 million NEVs per year from 2020 to 2022. A vehicle price limit for passenger cars of CNY300,000 has also been introduced. The NEV subsidy level is currently less in China than in European countries as well as in the US, showing the Chinese NEV market’s diminishing dependence on subsidies. Bottom Line: The country’s NEV production and sales will get supercharged by continuing favorable polices and by increasing consumer interest in NEVs during 2021-2030. We expect China’s NEV sales to reach 12 to 13 million units in 2030, eight to nine times its 2020 level of 1.37 million units. Growing China’s Competitiveness In The Global NEV Supply Chain The global NEV market has two main subsectors – plug-in hybrid electric vehicles (PHEV) and battery electric vehicles (BEV). The former can be operated in either the electric-powered mode or internal-combustion engines (ICE) mode. The BEVs can only run in electric mode and are also called pure electric vehicles. Traditional ICE vehicle manufacturers from Europe, US, Japan, and South Korea have more competitive advantages in the global PHEV subsector supply chain due to their long-term dominance in the global traditional ICE vehicle market. Chart 9BEVs Account For Over 80% Of Chinese NEV Sales China has been putting more focus on the new BEV market as it has enabled a level playing field with traditional ICE vehicle players. Hence, China has stronger competitiveness in the global BEV subsector. BEVs account for approximately 82% of Chinese NEV sales (Chart 9). According to China-SAE, this ratio could reach 95% by 2035 as China will increase its development of the BEV market and the adoption of BEV vehicle options.   We expect China’s competitiveness will continue to grow along the global NEV supply chain, especially in the BEV subsector. Having the largest domestic NEV market in the world gives China the advantage of attracting NEV manufacturers and building a more integrated global supply chain. During 2017-2020, accumulated world NEV sales were about 8.8 million units, with the largest share of 49% coming from China, higher than 31% for Europe and 14% for the US (Chart 10).   China is the largest NEV battery producer in the global NEV supply chain. The battery is the most important component of a NEV, and its technological progress holds the key to transitioning away from fossil fuel dependence. Data shows that six out of the world’s top ten NEV battery producers are Chinese companies, together accounting for 41% of global battery sales in kwh last year (Chart 11). Chinese company CATL has been the largest NEV battery producer for the past four years. Chart 10China Has The Largest NEV Market In The World Chart 11Chinese Companies: Major Players In The Global NEV Battery Market The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s much larger scale of EV users and related policy support. This allows China to collect more NEV charging-related data, which may be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development.  The development of the 5G network is much more advanced in China than in any other countries. This allows NEV makers to work closely with IT/internet companies such as Huawei, Baidu, Tencent and Alibaba to test integrated applications such as the autonomous driving and AI functions of NEVs. This will help promote the technology advancement related to NEVs in all aspects in China. Chart 12Chinas NEV Net Exports Are Set To Go Up Due to its competitive advantages, China has become a net exporter of electric vehicles (Chart 12). In 2019, Chinese NEV sales abroad accounted for only 1.7% of the world total in US dollar terms, far below the US (31%), Germany (15%), and South Korea (9%). We expect growing competitiveness will allow China to gain share in global NEV exports. The area China needs to work on the most along the NEV supply chain is the design/manufacturing of automotive chips. There is still no Chinese company among the top ten global auto chip semiconductor companies based on sales revenue (Chart 13). Chart 13China’s Greatest Weaknesses Lie In Automotive Chip Design/Manufacturing Non-Chinese companies account for about 90% of the global auto chip supply while China contributes no more than 5%. The current automotive chip shortage has done much more severe damage to automakers in China than in any other country. Bloomberg recently reported the global auto industry might lose US$61 billion of 2021 sales from chip shortages, with 42% of the losses from China. In the recent National People’s Congress, the Chinese government reiterated the importance of addressing this weak link, with an urgency on reducing the country’s dependence on foreign auto chips. Bottom Line: China will become globally more competitive in the NEV supply chain. Impact On Commodity Markets The evolution in China’s NEV markets in this decade will have various impacts on commodities such as crude oil, copper, nickel, cobalt, and lithium. During 2021-2030, massive NEV adoption will only modestly reduce Chinese crude oil consumption for the transportation sector, while significant growth in NEV/charging pole/battery production will increase the country’s copper demand. Meanwhile, as NEV battery production requires raw materials including nickel, cobalt and lithium, rapid growth in NEV battery production will also have different impacts on these commodity markets.    Crude oil: In 2019, the total number of vehicles in China was 252.6 million units and the country’s total gasoline and diesel consumption was about 6,800 thousand barrels per day (kbpd) of crude oil equivalent. This equals 26.7 kbpd per 1000 vehicles. Annual NEV sales in China will rise from 1.37 million units in 2020 to about 12 million units in 2030. Assuming all these NEVs are only using their electric battery, this will cut oil consumption/imports by an increasing amount every year, ranging from 50 kbpd in 2021 to 320 kbpd in 2030. The reduction from increased NEV sales will have a relatively minuscule impact on China’s total crude oil imports. A 50-kbpd reduction in 2021 would account for less than half a percent of China’s 2020 crude oil imports. By 2030, this number could potentially rise to 1-3%, but is still insignificant. Copper: An average gasoline powered car uses only about 20kg of copper, while a hybrid car uses about 40 kg and a fully electric car uses roughly 80kg. In addition, NEV batteries and charging station chargers also require copper. Table 1 shows our rough calculation of the copper demand from the expansion of Chinese NEV market. Chinese copper demand may increase by 210 thousand tons in 2021 and by about 1,500 thousand tons in 2030. To put this into perspective, China consumed about 15 million tons of copper in 2020 based on World Bureau of Metal Statistics (WBMS) data. The increase in copper demand in 2021 is only 1.4% of 2020 copper consumption in China. However, when it increases to 1,500 thousand tons in 2030, it will account for 10% of China’s current copper consumption. Table 1China's Copper Demand Due To EV Adoption In 2021 And 2030 Chart 14Chinas NEV Boom Will Have A More Positive Impact On Nickel And Lithium Demand Than On Cobalt Demand Nickel: The NEV battery technology is on a trend to reduce the use of cobalt given its high price and limited supply, while increasing the use of nickel. This will be a long-term positive factor for nickel prices (Chart 14, top panel). Cobalt: EV battery makers are trying to reduce or even avoid the use of cobalt. In the next couple of years, the demand for cobalt will likely remain strong as the technology of non-cobalt batteries is still in the developing stage. Non-cobalt batteries in development include solid-state , lithium-sulphur, sodium-ion and lithium-air batteries. However, cobalt prices may face increasing headwinds in the longer term (Chart 14, middle panel). Lithium: Lithium is a very abundant mineral produced from either brines or hard rock sources, with products from clays also in the pipeline. There is no structural constraint on global lithium production. Lithium prices may remain elevated in the near term but as the supply catches up over a longer run, we expect lithium prices to go down (Chart 14, bottom panel). Bottom Line: The massive growth in the Chinese NEV market in this decade will have a small negative impact on crude oil demand and a more positive impact on commodity demand such as copper, nickel, cobalt, and lithium. However, cobalt may face a substitution risk due to its elevated prices while lithium may face the risk of increasing supply. Investment Implications On NEV-related Stocks Chart 15The Chinese NEV stocks: A Good Long-term Investment, But We Recommend Waiting For A Better Entry Point We believe share prices of the Chinese NEV makers and NEV battery producers will deliver considerable positive long-term returns. The basis for this assumption is that many of them will experience strong revenue growth over this decade. While NEV maker stock prices have recently fallen considerably, we think they are still overpriced and recommend waiting for a better entry point (Chart 15).    Ellen JingYuan He     Associate Vice President ellenj@bcaresearch.com   Footnotes 1Source: “Technology Roadmap 2.0 for Energy-Saving and New Energy Vehicles,” released on October 27, 2020 by the China Society of Automotive Engineers (China-SAE). 2For example, as part of China’s 2012 “Energy-Saving and New Energy Vehicle Industry Development Plan (2012–2020),” the central government allocated over $15 billion to support the development of energy-efficient vehicles and NEVs, pilot car projects, and electric vehicle infrastructure. Source: "Chinese Government Support for New Energy Vehicles as a Trade Battleground", published by The National Bureau of Asian Research" on September 27, 2017. 3For example, the central government had provided 60,000 yuan (approximately $8,700) and 50,000 yuan (approximately $7,250) per car in subsidies for electric vehicles and plug-in hybrid vehicles, respectively, covering 40%–60% of the cost of the vehicle. Local governments also created their own subsidy programs that provided additional discounts for NEV purchases through cash subsidies, free parking, or free license plates. Source: "Chinese Government Support for New Energy Vehicles as a Trade Battleground", published by The National Bureau of Asian Research" on September 27, 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights We are lowering our expectation for oil-demand growth this year, bringing it more in line with levels expected by OPEC, the IEA and EIA.  Our GDP-driven demand estimates have proven too bullish for 1Q21, considering the wide margin by which we missed actual demand in January and February.  Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month.  For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We continue to expect Brent prices to reflect an accommodation between Russia's and KSA's preferred Brent ranges of $50-$55/bbl and $70-$75/bbl, respectively.  We are keeping our forecast for average prices at $65/bbl and $70/bbl for this year and next, with WTI averaging $2-$3/bbl below that (Chart of the Week). Brent benchmark pricing confusion subsided, following the decision of S&P Global Platts to revert to free-on-board (FOB) reporting of prices.  However, as the center of gravity for crude oil demand settles on Asia, confusion around the North Sea benchmark could provide an opening for regional benchmarks and consolidation of futures platforms trading crudes delivered to the region. Feature The decision by the Kingdom of Saudi Arabia (KSA) to voluntarily remove 1mm b/d of its production from the market over February – April will be remembered as one of the more prescient reads on the state of global oil demand during the COVID-19 pandemic. KSA's insistence on seeing improvement in actual demand – as opposed to forecasted demand – before it commits to returning production to the market could not have been more clear-sighted. The upcoming April 1 meeting of OPEC 2.0 will convey useful information to the market re changes, if any, to the production-management strategy of the coalition, which is led by KSA and Russia. Perhaps the most important information coming out of the meeting will be how KSA reads the current state of global oil demand, as it has not committed to a date-certain when it will return this production to market. We expect the Kingdom to extend its production cuts and to lobby for continued restraint by the other member states of OPEC 2.0 at the meeting. Going into the meeting, OPEC 2.0 will be assessing global demand against a deteriorating public-health backdrop in important consuming markets. The EU's policy failures in securing sufficient vaccinations to protect its population, and public-health missteps regarding the AstraZeneca vaccine continue to retard Europe's efforts to contain the pandemic.1 Chart of the WeekOPEC 2.0 Expected To Maintain Production Discipline Increasing lockdowns in several EU countries and a higher likelihood of a resurgence in COVID-19 infection rates in the US – particularly in the states that are reopening before they have achieved herd immunity or have vaccinated a large share their populations – will slow demand recovery. The annual Spring Break holidays in the US potentially could become a world-class super-spreader event. Elsewhere, LatAm is distressed, particularly Brazil, which, like the EU, has misjudged and mishandled its vaccination policy and rollout, leaving its populations at higher risk for infection. This also has the attendant risk of producing an environment ripe for further COVID-19 mutations and the spread of new variants. Lower Oil Demand Forecast For 2021 We were wrong on our call expecting stronger demand growth in 1Q21 – our consumption forecasts exceeded realized demand an average of 2.3mm b/d in 1Q21. We are now more aligned with demand expectations of IEA, EIA, and OPEC (Chart 2). Our expectation for oil demand growth this year is lowered to 5.5mm b/d, down from 6.6mm b/d last month. For 2022, we are increasing our growth assumption to 4.1mm b/d, up from 2.8mm b/d. We expect non-OECD oil consumption, our proxy for EM demand, to average 53.2mm b/d this year and 55.5mm b/d next year, vs. 54mm b/d and 55.4mm b/d last month. DM demand, proxied by OECD oil consumption, is expected to average 44.5mm b/d and 46.3mm b/d next year, versus our previous forecast of 44.9mm and 46.3mm b/d last month. Chart 2Lower Oil Demand In 2021, Higher Next Year We continue to expect the massive fiscal and monetary stimulus to support markets and lead to stronger growth going forward. The recently approved package by the US Congress calling for an additional $1.9 trillion of fiscal stimulus will have global knock-on effects, which will be bullish for commodity demand, once the COVID-19 pandemic is contained (Chart 3). Chart 3Pandemic Recovery Will Spur Pent-Up Demand OPEC 2.0 Production Discipline Persists The salient feature of the oil market during the pandemic has been the cohesion of OPEC 2.0 and its production discipline. We expect that to continue going into and coming out of the coalition's April 1 meeting. Our view that OPEC 2.0 's overall strategy as the dominant producer in the market is to calibrate the level of supply to the level of demand remains intact. We expect production for the coalition to average 46.0mm b/d in 2021 and 46.2mm b/d in 2022 (Chart 4). We do not expect OPEC 2.0 to raise production, given the increasing uncertainty around demand vis-à-vis getting the COVID-19 pandemic under control in large consuming markets like the EU and LatAm, and higher infection rates out of the US. However, as we noted above, we are closely watching what KSA does and says at the upcoming meeting for any clue that global demand is improving faster than we now expect. Chart 4OPEC 2.0 Production Discipline Persists Outside OPEC 2.0, our expectation for the bellwether US shale-oil producers' output remains relatively unchanged. We continue to expect production to move higher, and to remain constrained by capital availability. US shale output is expected to average 10.7mm b/d this year, and 12.1mm b/d next year. In our modeling, the shale producers lead the price-taking cohort, which produces whatever the market allows it to produce. We continue to expect capital-market discipline to keep US oil producers from getting too far out ahead of their balance sheets' ability to profitably grow production. The same holds for producers outside the OPEC 2.0 coalition ex-US (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Markets Balance On OPEC 2.0 Discipline OPEC 2.0's production strategy will keep markets balanced, as relatively high compliance among those producers capable of increasing production is observed and markets are not over-supplied (Chart 5). This will allow inventories to continue to draw then stabilize around mid-year. It is important to point out that this balancing is an iterative process, driven by OPEC 2.0's read on the state of demand, which, perforce, is occurring with lags in the data it is responding to. We continue to keep a weather eye on the USD, given the impact it has on commodity fundamentals. We continue to expect dollar weakening and model for that, but the path of the USD has been difficult to call, given it is highly correlated with global economic policy uncertainty, which is heavily influenced by the evolution of the COVID-19 pandemic (Chart 6). Chart 5Markets Remain Balanced... Chart 6The USD's Evolution Remains Important A Hue and Cry In Brent Additional uncertainty is entering oil markets from an unlikely corner: The Brent benchmark pricing index used to set prices on some two-thirds of all the oil traded in the world. Brent benchmark pricing was thrown into wide-eyed confusion when S&P Global Platts – the leading price reporting agency for the index used as a reference in Brent physical contracts (Dated Brent) – decided to convert the index from a free-on-board (FOB) index to a cost-insurance-freight (CIF) index. Platts' proposed Brent reporting changes two weeks ago essentially would have transformed the pricing index from a pure spot index that assumes the buyer will arrange insurance and freight after purchasing a cargo at a North Sea terminal into a delivered index reflecting CIF-Rotterdam terms provided by the seller. After a great hue and cry went up, Platts reverted to quoting Brent on an FOB basis. But that hardly ends the drama. Brent production is collapsing – by next year, only one 600k-barrel cargo a day of Brent will be loaded out of North Sea terminals. This is a very thin reed supporting the global oil market's primary price index. In an effort to expand the Brent pricing pool, Platts also is looking to include US WTI in one form or another, but nothing's been settled upon to date. The confusion around Brent pricing comes as the center of gravity for crude oil demand and trading continues its inexorable shift to Asia. This could provide an opening for regional benchmarks – e.g., the UAE's Murban crude oil, which supports a just-launched futures contract calling for delivery in Asia, where most of the demand for oil is met by Middle East suppliers. It could even allow for consolidation of other futures platforms in the region (e.g., the Dubai Mercantile Exchange), which also are used to price and hedge Asia-bound crude cargoes out of the Gulf. As interesting and complex as the global oil market is, it is nothing without a viable pricing benchmark. Much of the world's oil business hinges on that index being determined by the price of a single cargo loaded every day. We will be following this with great interest.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish An exceptionally cold winter resulted in a sharp drawdown US natgas inventories down, which are expected to end the 2020-21 winter season at 2021 at 1.6 Tcf by the US EIA's reckoning (Chart 7). This would be 13% lower than the 5-year average level of inventories, according to the EIA. Over the April-October injection season, EIA is expecting natgas inventories to finish at ~ 3.7 Tcf, or ~ 2% below their 5-year average. Spot natgas prices at Henry Hub, LA – the delivery point for NYMEX/CME futures – averaged $5.35/MMBtu in February, the highest level since February 2014, the EIA noted. Natural gas for April 2021 delivery at Henry Hub closed at $2.562/MMBtu on Tuesday. Base Metals: Bullish COMEX copper came close to its 2011 highs late last month, at $4.30/lb but has since retreated.  However, we believe fundamental supply-demand factors will keep copper prices moving higher over the longer term. As highlighted in an earlier report (BCA Research - Renewables, China's FYP Underpin Metals Demand), the move to EVs and renewable energy will keep demand for copper and the overall base metals complex well-bid during this decade. The International Renewable Energy Agency (World Energy Transitions Outlook: 1.5°C Pathway (Preview) (irena.org)) reported on Tuesday that copper-intensive renewable power capacity will have to increase by more than 10-fold by 2050 to avert severe climate change. On the supply side, in our recent report entitled BCA Research - Copper's Supply Challenges, we noted falling copper investment and declining copper ore quality inexorably will increase production costs. Only higher copper prices will incentivize producers to increase mining activity. Rising demand and stagnant supply will put copper supply-demand balances in a deficit over the short-to-medium term, causing inventories to decline over this period as well.  Precious Metals: Bullish The sharp run-up in 10-year US real rates since the end of 2020 pulled gold prices from down from their 2021 high of ~ $1,950/oz in January to ~ $1,680/oz earlier this month (Chart 8). Price have since rebounded above $1,740/oz as real rates weakened. We expect markets to re-price gold when it becomes apparent the rally in rates was more a function of higher growth expectations for the US economy than a higher likelihood of Fed tightening. Our view that the Fed's ultra-accommodative monetary policy and massively expansive US fiscal policy will spur growth and inflation has not changed. We expect the Fed to remain behind the inflation curve in its rate hikes, which will keep US real rates on their downward trajectory. Chart 7 Chart 8     Footnotes 1     Please see Extent of damage to AstraZeneca vaccine’s perceived safety in Europe revealed published by yougov.co.uk 7 March 2021.  See also States lift Covid restrictions, drop mask mandates and reopen businesses despite warnings from Biden officials published by cnbc.com 11 March 2021, and European travel restrictions: Non-essential travel curbed published by dw.com 15 March 2021. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Summary of Closed Trades

Special Report

Highlights The Biden administration will not attempt a major diplomatic “reset” with Russia. The era of engagement is over. Russia faces rising domestic political risk and rising geopolitical risk at the same time. A war in the Baltics is possible but unlikely. Putin has benefited from taking calculated risks and wants to keep the US and Europe divided. The Russian economy is weighed down by structural flaws as well as tight policy. Investors focused on absolute returns should sell Russian assets. For EM-dedicated investors, our Emerging Markets Strategy recommends a neutral allocation to Russian stocks and local currency bonds and an overweight allocation to US dollar-denominated sovereign and corporate debt. Feature “We will not hesitate to raise the cost on Russia.” – US President Joseph R. Biden, State Department, February 4, 2021 The Biden presidency will differ from its predecessors in that there will not be a major attempt to engage Russia at the outset. Previous US presidents sought to reach out to their Russian counterparts to create room for maneuver. This was true of Presidents Reagan, Clinton, Bush, Obama, and Trump. Even Biden has shown a semblance of reengagement by extending an arms reduction pact. But investors should not be misled. The United States and the Democratic Party have shifted their approach to Russia since the failure of the diplomatic “reset” that occurred in 2009-11 and Washington will take a fundamentally more hawkish approach. Russia is not Biden’s top foreign policy focus – that would be Iran and China. But as with China, engagement has given way to Great Power struggle and hence there will not be a grace period before geopolitical tensions re-escalate. Tensions will keep the risk premium elevated for Russia’s currency and assets. The same is true of emerging European markets that get caught up in any US-Russia conflicts. Putin, Biden, And Grand Strategy Understanding US-Russia relations in 2021 requires a brief outline of both the permanent and temporary strategies of the United States and Russia. Russia’s grand strategy over the centuries has focused on establishing a dominant central government, controlling as large of a frontier as possible, and maintaining a high degree of technological sophistication. The nightmare of the Russian elite consists of foreign powers manipulating and weaponizing the country’s extremely diverse peoples and territories against it, reducing the world’s largest nation-state to its historical origin as a geographically indefensible and technologically backward principality. Chart 1Russia's Revival In Perspective Russia can endure long stretches of austerity in order to undermine and outlast rival states in this effort to achieve defensible borders. Russia’s strategy since the rise of President Vladimir Putin has focused on rebuilding the state and military after the collapse of the Soviet Union so as to restore internal security and re-establish political dominance in the former Soviet space (Chart 1). Partial invasions of Georgia and Ukraine and a military buildup along the border with the Baltic states show Russia’s commitment to prevent American or US-allied control of strategic buffer spaces. Expansion of the North Atlantic Treaty Organization (NATO) and the European Union poses an enduring threat to Putin’s strategy. Putin has countered through conventional and nuclear deterrence as well as the use of “hybrid warfare,” trade embargoes, cyberattacks, and disinformation. To preempt challengers within the former Soviet space Russia also maintains a “veto” over geopolitical developments outside that space, as with nuclear proliferation (Iran), civil wars (Syria, Libya), or resource production (OPEC 2.0). The evident flaw in Putin’s strategy is the decay of the economy, the long depreciation of the ruble, and the drop in quality of life and labor force growth. See the macro sections below for a full discussion of these negative trends. Compare the American strategy: America’s grand strategy is to control North America, dominate the oceans, prevent the rise of regional empires, and maintain the leading position in technology and talent. A nightmare for American policymakers would be a collapse of the federal union among the disparate regions and the rise of a secure foreign empire that could supplant the US’s naval preponderance. This is especially true if the rival empire were capable of supplanting US supremacy in technology, since then the US would not even be safe within North America. America’s strategy under the Biden administration is to mitigate internal political divisions through economic growth, maintain its global posture by refurbishing alliances, and reassert its technological primacy by encouraging immigration and trade. The status quo of strong growth and rising polarization has been beneficial for US technology but not for foreign and defense policy (Chart 2). Political polarization has prevented the US from executing a steady long-term strategy for over 30 years. As a result, Russia has partially rebuilt the Soviet sphere of influence and China is constructing a sphere of its own. A few conclusions can be drawn from the above. First, China poses a greater challenge to the US than Russia from a strategic point of view. China is capable of creating a regional empire that can one day challenge the US for technological leadership. Modern Russia must summon all its strength to carve out small pieces of its former empire – it is not a contender for supremacy in technology or in any regions other than its own. Second, however, Russia’s resurgence under Putin poses a secondary challenge to American grand strategy. Russia can undermine US strategy very effectively. The effect today is to aid the rise of China, on which Russia’s economy increasingly depends (Chart 3). Chart 2US Tech Boom Coincided With Disinflation, Polarization Chart 3Russia’s Turn To The Far East Unlike the US, Russian leadership has not changed over the past year – and Vladimir Putin’s tactics are likely to be consistent. These were underscored by the constitutional revisions approved by popular vote in September 2020. Not only will Putin be eligible to remain president till 2036 but also Russia reaffirmed its willingness to intervene militarily into neighboring regions by asserting its right to defend Russian-speaking peoples everywhere. Finally, Russia ensured there would be no giving away of territories, thus ruling out a solution on Ukraine over Crimea.1 Bottom Line: The US-Russia conflict will continue under the Biden administration, even though Biden’s primary concern will be China. Biden’s Foreign Policy Intentions It is too soon to draw conclusions about Biden’s foreign policy “doctrine” as he has not yet faced any major challenges or taken any major actions. Biden’s first two foreign policy speeches and interim national security strategy guidance establish his foreign policy intentions, which will have to be measured against his administration’s capabilities.2 His chief intentions are to revive the economy and court US allies: First, Biden asserts that every foreign action will be taken with US working families in mind, co-opting Trump’s populism and emphasizing that US international strength rests on internal unity which flows from a strong economy. This goal will largely be met as the administration is already passing a major economic stimulus and is likely to pass a second bill with long-term investments by October. The impact on Russia is mixed but the Biden administration is largely correct that a strong recovery in the US economy and reduction in political polarization will be a major asset in its dealings with Russia and other rivals. Second, Biden asserts that diplomacy will be the essence of his foreign policy. He aims to create or rebuild an alliance of democracies that spans from the UK and European Union to the East Asian democracies. The two goals of economy and diplomacy are connected because Biden envisions the democracies working together to make “historic investments” in technology, setting global standards and rules of trade, and defending against hacking and intellectual property theft. This goal will have mixed success: the EU and US will manage their own trade tensions reasonably well but they will disagree on how to handle Russia and especially China. Biden explicitly sets up this alliance of democracies against autocracies. He calls China the US’s “most serious competitor” but also highlights Russia: “The challenges with Russia may be different than the ones with China, but they’re just as real.”3 Table 1 shows the Biden administration’s notable comments and actions on Russia so far. What is clear is that the US will not seek an extensive new diplomatic engagement with Russia.4 The failure of the Obama administration’s “diplomatic reset” with Russia has disabused the Democratic Party of the notion that strategic patience and outreach are the right approaches to Putin’s regime. The reset and its failure are described in detail in Box 1. Table 1Biden Administration's First 100 Days: Key Statements And Actions On Russia Box 1: What Was The US-Russia Diplomatic Reset? What Comes Next? Most American presidents open their foreign policy with overtures to Russia to create space to maneuver, given that Russia is capable of undermining US aims in so many areas. The Barack Obama administration made a notable effort at this in 2009, which was dubbed the “diplomatic reset.” It was a rest because relations had collapsed over Russia’s use of natural gas pipelines as a weapon against Ukraine and especially its invasion of Georgia in 2008. Then Vice President Joe Biden led the reset. President Putin had stepped aside in accordance with constitutional term limits, putting his protégé Dmitri Medvedev in the presidential seat, which supported the reset because Medvedev had at least some desire to reform Russia’s economy. The reset lasted long enough for Washington and Moscow to agree on the need for a strategic settlement on the question of Iran – which would culminate in the 2015 nuclear deal – as well as to admit Russia to the World Trade Organization (WTO). But the aftermath of the financial crisis proved an inauspicious time for a reset. Along with the Arab Spring, popular unrest emerged in Moscow in 2011 and western influence crept into Ukraine – all of it allegedly fomented by Washington. Putin feared he would lose central control at home and frontier control abroad. He also sensed an opportunity given that commodity prices were filling state coffers while the US was focused on domestic policy, increasingly polarized, and unwilling to make the sacrifices necessary to solidify its influence in eastern Europe. Russia’s betrayal of the reset resulted in a string of losses for the US and its European allies: the Edward Snowden affair, the invasion of Ukraine, the intervention in Syria, the meddling in the 2016 US election, and most recently the SolarWinds hack. The Obama administration refrained from a strong reaction over Crimea partly to seal the Iran deal. But Russia pressed its advantage after that. It is doubtful that Russia’s influence decided the 2016 election but, regardless, the Democratic Party fell from power and then watched in dismay as the Trump administration revoked the Iran deal. Now that the Democrats are back in power they will seek to retaliate not only for the SolarWinds hack but also for the betrayal of the reset. However, retaliation will come at a time of Washington’s choosing. Bottom Line: The Biden administration’s foreign policy will emphasize alliances of democracies in opposition to autocracies like Russia and China. Biden is planning a more hawkish approach to Russia than previous recent administrations. Biden’s Foreign Policy Capabilities There are a few clear limitations on Biden’s foreign policy goals. First, his administration will largely be focused on domestic priorities. In foreign affairs there is at best the chance to salvage the Obama administration’s foreign policy legacy. Second, Biden’s dealings with China will take up most of his time and energy. China’s fourteenth five-year plan contains a state-driven technological Great Leap Forward that will frustrate any attempt by Biden to reduce tensions. Biden will not be able to devote much attention to Russia if he pursues China with the attention it deserves, i.e. to secure US interests yet avoid a war.5 Third, Biden will be limited by allied risk aversion and the need for consensus on difficult decisions. If his diplomacy with Europe is successful then China and Russia will face steeper costs for any provocative actions. If it fails then European risk aversion will prevail, the allies will remain divided, and China and Russia will faces few costs for maintaining current policies. Table 2Russia’s Pipeline Export Capacity The Nordstream Two pipeline will be a key test of European willingness to follow the US’s lead even if it means taking on greater risks: Nordstream Two is a major expansion of Russian-EU energy cooperation but contrary to America’s national interest. German Chancellor Angela Merkel still backs the project despite Russia’s poisoning and imprisonment of dissident Alexei Navalny and forceful suppression of protests. However, Merkel is a lame duck and there is some evidence that German commitment to the project is fraying.6 Biden has not tried to halt the pipeline project, but he still could. There are only 100 miles left to the pipeline. Construction resumed in January after a hiatus last year due to US sanctions. The project will take five months to complete at the rate of 0.6 miles per day. The Biden administration still has time to halt the project through sanctions. If it does, the Russians will react harshly to this significant loss of economic and strategic influence over Europe (Table 2). Biden will have a crisis on his hands in Europe. If Biden does nothing on Nordstream, then Russia will conclude that his administration is not serious and take actions that undermine the Biden administration in accordance with Putin’s established strategy. This would prompt Biden to act on his pledge to stand up to Putin’s provocations. Whereas if Biden imposes sanctions to halt Nordstream, Russia will retaliate. Elsewhere it is possible that Biden will be too confrontational with Russia for Europe’s liking. Biden plans to increase support for Ukraine, which will prompt an increase in military conflict this spring.7 The US will promote democracy across eastern Europe, including Belarus, and it is possible that Russia could overreact to this threat of turning peripheral regimes against Russia. The EU is on the front lines in the conflict with Russia and will not want the US to act aggressively – but the US is specifically seeking to “raise the cost” on Russia for its aggression.8 Bottom Line: Russia is not Biden’s priority. But his pledge both to promote democracy and retaliate against Russian provocations sets the US up for a period of higher tensions. US-Russia Engagement On Iran? Will the US not need to engage Russia to achieve various policy goals? Specifically, while highlighting competition, Biden says he will engage Russia and China on global challenges, namely the pandemic, climate change, cybersecurity, and nuclear proliferation. Nuclear proliferation is the only one of these areas where US-Russia cooperation might matter. After all, there is zero chance of cybersecurity cooperation. Whereas on nuclear issues, the US and Russia immediately extended the New START arms reduction treaty through 2026 and could also work together on Iran. Biden is determined to restore the Obama administration’s 2015 nuclear deal. Moscow does not have an interest in a nuclear-armed Iran so there is some overlap of interest. The Iranian issue will require Biden to consider whether he is willing to make major concessions to Russia: Compromise the hard line on Russia: A new Iranian administration takes office in August. Biden is likely to have to rush a return to the 2015 nuclear deal before that time if he wants a deal with Iran. Otherwise it would take years for Biden and the Europeans to reconstitute the P5+1 coalition with Russia and China and negotiate an entirely new deal. Biden would have to make major concessions to Russia and China. His stand against autocracy would be compromised from the get-go. Maintain the hard line on Russia: The alternative is for Biden to rejoin the 2015 nuclear deal with a flick of his wrist, with Iranian President Hassan Rouhani signing off by August. Biden would extract promises from the Iranians to keep talking about a broader deal in future. In this case Biden would not need to give the Russians or Chinese any new concessions. Chart 4China Enforces Iran Sanctions The Biden administration will be keen to make sure that Russia does not exploit the US eagerness for a deal with Iran as it did with the original deal in 2014-15. Iran has an individual interest in restoring the deal, which is to gain sanction relief and avoid air strikes. The Europeans have helped Iran keep the deal alive. China is at least officially enforcing sanctions (Chart 4). Russia is also urging a return to the deal and would be isolated if it tried to sabotage the deal. This could happen but it would escalate the conflict between the US and Russia. Otherwise, if a deal is agreed, the US will continue putting pressure on Russia in other areas. Bottom Line: The Biden administration is likely to seal an Iranian nuclear deal without any major concessions to Russia. Tail Risk – A War In The Baltics? It is well established that the Putin regime will use belligerent foreign adventures to distract from domestic woes. Just look at poor opinion polling tends to precede major foreign invasions (Chart 5). With the eruption of social unrest in the wake of COVID-19 and the imprisonment of opposition leader Alexei Navalny, it is entirely possible that Russia will activate this tool again. The implication is a new crisis in Ukraine, a larger Russian military presence in Belarus, or further escalation of hybrid warfare or cyberwar in other areas. What about an invasion of the Baltic states of Latvia, Lithuania, and Estonia? Unlike other hotspots in Russia's periphery this is a perennial "black swan" risk that would equate with a geopolitical earthquake in Europe. A Baltic war is conceivable based on Russia’s geographic proximity, military superiority, and military buildup on the border and in the Kaliningrad exclave. The combined military spending of NATO dwarfs that of Russia but NATO is extremely vulnerable in this far eastern flank (Chart 6). However, Europe would cutoff Russia’s economy and join the US in countermeasures while Russia would be left to occupy hostile countries.9 Chart 5Putin Lashes Out When Popularity Falls The Baltic states are members of NATO and thus an attack on one is theoretically an attack on all. President Trump ultimately endorsed Article V of the NATO treaty on collective self-defense and President Biden has enthusiastically reaffirmed it. The guarantee is meaningless without greater military support to enforce it, so NATO could try to reinforce its forward presence there. This could provoke Russia to retaliate, likely with measures short of full-scale war. Chart 6Russia Would Be Desperate To Invade Baltics Since the wars in Iraq and Afghanistan, US rivals have observed that the American public lacks the willingness to fight small wars. It responded weakly to Russia’s invasion of Crimea and China’s encroachments in the South China Sea and Hong Kong. However, foreign rivals do not know whether the unpredictable US leadership and public are willing to fight a major war. Hence Russia and China are likely to continue to focus on incremental gains and calculated risks rather than frontal challenges. Based on the Biden administration’s moderate political capital (very narrow electoral and legislative control), the US will continue to be divided and distracted. Russia, China, and other powers will test the administration and make an assessment before they attempt any major foreign adventures. The testing period is imminent, however, and thus holds out negative surprises for investors. It is also possible that Biden could make the first move – particularly on Russia, where retaliation for the 2020 SolarWinds hack should be expected. Bottom Line: A full-scale war in the Baltics is possible but unlikely as the Russians have succeeded through calculated risks whereas they face drastic limitations in a major war against the NATO alliance. Growth Weighed Down By Tight Policy We now turn to Russia’s domestic economic conditions. Here, Russia also faces major challenges. Authorities are determined to keep a tight lid on both monetary and fiscal policies. In particular, high domestic borrowing costs and negative fiscal thrust will weigh down domestic demand over the next six-to-12 months. There are three reasons authorities will maintain tight monetary and fiscal policies: First, concerns about high inflation are deeply entrenched among consumers, enterprises, and policymakers. Russian consumers and businesses tend to have higher-than-realized inflation expectations. This is due to the history of high inflation as well as stagflation in Russia. A recent consumer poll reveals that rising prices are the number one concern among households (Table 3). Remarkably, the poll was conducted in August amid the height of the pandemic and high unemployment. This suggests that households do not associate growth slumps with lower inflation but rather fear inflation even amid a major recession (i.e., worry about stagflation). Table 3Fear Of Inflation Prevalent Amongst Consumers’ Expectations Second, Central Bank of Russia Governor Elvira Nabiullina is one of the most hawkish central bankers in the world. Her early tenure was characterized by the 2014-15 currency crisis and a major inflation spike. To combat structural inflation and bring down persisting high inflation expectations, the central bank has adopted a very hawkish policy stance since 2014. There is no sign that the central bank is about to change its hawkish policy. Specifically, monetary authorities have been syphoning liquidity from the banking system. With relatively tight banking system liquidity and high borrowing costs, private credit growth will fail to accelerate from current levels. Third, the government still projects an austere budget for 2021. The fiscal thrust will be -1.7% of GDP this year (Chart 7). While a moderate spending increase is likely, it will not be sufficient to boost materially domestic demand. There are no signs yet that the fiscal rule10 will be further relaxed, potentially releasing more funds for the government to spend this year. The fiscal rule has become an important gauge of the country’s ability to weather swings in energy prices. In addition to the points listed above, policymakers’ inflation worries stem from the economy’s structural drawbacks: Despite substantial nominal currency depreciation in recent years, Russia runs a current account deficit excluding energy. When a country runs a chronic current account deficit, including periods of major domestic demand recessions and currency devaluations, it is a symptom of a lack of productivity gains. Real incomes grew at a quick pace from the mid-1990s, largely driven by the resource boom in the 2000s. Yet rising real incomes were not complemented by expanding domestic manufacturing capacity to produce consumer and industrial goods. As such, imports of consumer goods and services rose alongside real incomes. Russia has been underinvesting. Gross fixed capital formation excluding resources industries and residential construction has never surpassed 10% of GDP in either nominal or real terms (Chart 8). Chart 7Russia: Fiscal Policy Will Remain Austere In 2021 Chart 8Russia: Underinvestment Within Domestic Sectors Geopolitical tensions with the West have discouraged FDI inflows and hindered Russian companies’ ability to raise capital externally. This has inhibited capital spending and ”know-how” transfer and, hence, bodes ill for productivity gains. Russian domestic industries are highly concentrated and, in some cases, oligopolistic in nature. This allows incumbents to raise prices. The number of registered private enterprises has fallen below early 2000s levels (Chart 9). Despite chronic currency depreciation, Russian resource companies have failed to grab a large share of their respective export markets. For instance, Russia’s oil market share of total global oil production has been flat for over a decade and the nation has been losing market share in the global natural gas industry. A shrinking labor force due to poor demographics and meager immigration complements Russia’s sluggish productivity growth and caps its potential GDP growth (Chart 10). Chart 9Russia: Increasing Industry Concentration Some positive signs are appearing in the form of import substitution. Since the Ukraine conflict in 2014 and the resulting Western sanctions, the government has enacted various laws and decrees to incentivize domestic production, and with it providing substitutions for imported goods. Their impact is noticeable in certain sectors. Chart 10Russia: Poor Potential Growth Outlook In particular, the country has invested heavily in the food industry, as food imports are 16% of overall imports. Agricultural sector output has been rising while imports of key food categories have declined. Recent decrees on industrial goods will likely boost domestic production of some goods and processed resources. Around 40% of Russian imports are concentrated in machinery, industrial equipment, transportation parts, and vehicles. Hence, raising competitiveness in production of industrial goods is essential for Russia to reduce reliance on imports. In short, fewer imports of goods for domestic consumption will make inflation less sensitive to fluctuations in the exchange rate. The current trend is mildly positive, but its pace remains slow. Bottom Line: Russia needs to raise its productivity and labor force growth and, hence, potential GDP growth to deliver reasonable high-income growth without raising inflation. The Cyclical OutLook: Worry About Growth, Not Inflation Cyclically, high domestic borrowing costs and lackluster fiscal spending will weigh down domestic growth and cap inflation for the next 12 months. Russia’s real borrowing costs are among the highest in the EM space. High borrowing costs are causing notable financial stress amongst corporate and household debtors. Commercial banks’ NPLs and provisions are high and rising (Chart 11). Unwilling to take on more credit risk, banks have shunned traditional lending and have instead expanded their assets into financial securities. This trend will likely persist and corporate and consumer credit will fail to boost investment and consumption. The recent pickup in inflation was primarily due to rising food prices and the previous currency depreciation pass-through. Chart 12 illustrates the recent currency appreciation heralds a rollover in core inflation. Chart 11Russia: High Borrowing Costs Are Leading To Higher Credit Stress Chart 12Russia: Inflation Will Rollover Due To Stable RUB In fact, a broad range of inflation indicators suggest that core inflation remains within the central bank target (Chart 13). These measures of inflation are less correlated with the ruble movements. Chart 13Russia: Inflation Is At Central Bank Target Of 4% Chart 14Russia: Tame Recovery In Domestic Activity High-frequency data suggest that consumer spending and business activity remain tame (Chart 14). Bottom Line: The latest uptick in Russia’s core CPI is likely transitory. Cyclical conditions for a material rise in inflation and hence monetary tightening are not in place. Investment Takeaways Chart 15Russia Underperforms Amid Commodity Bull Run Russia’s sluggish economy and austere policy backdrop suggest that the fires of domestic political unrest will continue to burn. While political instability may force the Kremlin to ease fiscal policy, the easing so far envisioned is slight. The implication is that Russia faces rising domestic political risk simultaneously with the rise in international, geopolitical risk stemming from the Biden administration’s efforts to promote democracy in Russia’s periphery and push back against its regional and global attempts to undermine the US-led global order. So far the totality of Russia’s risks have outweighed the benefits of the global economic recovery as Russian assets are trailing the rally in commodity prices (Chart 15). The ruble is above the lows reached at the height of the Ukraine crisis, whether compared to the GBP or the EUR, suggesting further downside when US-Russia tensions spike (Chart 16). The currency is neither cheap nor expensive at present (Chart 17). Chart 16Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Chart 17Russia: The Ruble Is Fairly Valued   Chart 18Geopolitical Risk Will Revive Despite Apparent Top Our Geopolitical Risk Indicator for Russia is forming a bottom, implying that global investors believe the worst has passed. This is a mistake and we expect the indicator to change course and price in new risk. The result will weigh on Russian equities, which are fairly well correlated with this indicator (Chart 18). Overall, we recommend investors who care about absolute returns to sell Russian assets. For dedicated EM equity as well as EM local currency bond portfolios, BCA's Emerging Markets Strategy recommends a neutral stance on Russia (Chart 19). Rising bond yields in the US will continue weighing especially on high-flying growth stocks. The low market-cap weight of technology/growth stocks in the Russian bourse makes the latter less vulnerable to rising global bond yields. Concerning local rates, we see value in 10-year swap rates, as tight monetary and fiscal policies will keep a lid on inflation. With the central bank unlikely to hike rates anytime soon, a steep yield curve offers good value in the long end of the curve for fixed income investors. Finally, orthodox macro policies will benefit fixed-income investors on the margin. In regard to EM credit (USD bonds) portfolio, the Emerging Markets Strategy team recommends overweighting Russia (Chart 20). The government has little local currency debt and minimal US dollar debt. Not surprisingly, Russia has been a low-beta credit market and it will outperform its EM peers in a broad sell off. Chart 19Russia: Move To Neutral Local Currency Bond Allocation Lastly, the Emerging Markets Strategy is moving Ukrainian local currency government bonds to underweight and closing the 5-year local currency bond position. Risks of military confrontation on the Ukraine front have escalated. Chart 20Russia: Remain Overweight On USD Credit     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Andrija Vesic Associate Editor Emerging Markets Strategy AndrijaV@bcaresearch.com   Footnotes 1 See Pavlo Limkin et al, “Putin’s new constitution spells out modern Russia’s imperial ambitions,” Atlantic Council, September 10, 2020, atlanticcouncil.org. 2 See White House, “Remarks by President Biden on America’s Place in the World,” February 4, 2021, and “Remarks by President Biden at the 2021 Virtual Munich Security Conference,” February 19, 2021, whitehouse.org. 3 See “Remarks … at the … Munich Security Conference” in footnote 2 above. 4 We first outlined this US-Russia disengagement in our last joint special report on Russia, “US-Russia: No Reverse Kissinger (Yet),” July 3, 2020, bcaresearch.com. 5 See Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Jamestown Foundation, February 1, 2021, Jamestown.org. 6 Biden’s “Interim National Security Strategic Guidance,” White House, March 3, 2021, whitehouse.org, reinforces this point by focusing most of its attention on China and largely neglecting Russia. 7 See “Kremlin concerned about rising tensions in Donbass,” Tass, March 4, 2021, tass.com. 8 One way in which this could transpire would be a carbon border tax. The EU says imposing a tariff on carbon-intensive imports will proceed unilaterally if there is not a UN agreement in November because it is a “matter of survival” for its industry as it raises green regulation. The Biden administration also promised in its campaign to levy a “carbon adjustment fee.” Russia, which is exposed as a fossil fuel exporter that does not have a carbon pricing scheme, says such a fee would go against WTO rules. See Kate Abnett, “EU sees carbon border levy as ‘matter of survival’ for industry,” Reuters, January 18, 2021, reuters.com; Sam Morgan, “Moscow cries foul over EU’s planned carbon border tax,” Euractiv, July 27, 2020, euractiv.com. 9 See Heinrich Brauss and Dr. András Rácz, “Russia’s Strategic Interests and Actions in the Baltic Region,” German Council on Foreign Relations, DGAP Report, January 7, 2021, dgap.org; Christopher S. Chivvis et al, “NATO’s Northeastern Flank: Emerging Opportunities for Engagement,” Rand Corporation, 2017. 10 The rule stipulates that a portion of oil and gas revenues that the government can spend is determined by a fixed oil price benchmark. Currently, the benchmark oil price stands at $42 per barrel. The fiscal rule also encompasses constraints on the National Welfare Fund withdrawals in oil prices below $42 per barrel.