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Highlights Clients countered our opinion that China’s economy has reached its cyclical peak. However, we have already incorporated the supporting facts into our analysis so they will not alter our cyclical outlook for the economy. The favorable external backdrop is a potential downside risk to China’s domestic economy, because the country’s pain threshold for reform is often positively correlated with global growth. We agree that an acceleration in local governments’ special-purpose bond issuance could boost infrastructure investment in the next six months, but we are skeptical about the magnitude of such support. China’s onshore and offshore stock markets remain firmly in a risk-off mode. For now, we recommend investors stay on the sidelines until some of the early indicators turn more bullish. Feature We spent the past week hosting virtual meetings with BCA’s clients in Europe and Asia. We presented our view that China’s economic recovery has likely peaked and escalating risks of a policy overtightening warrant an underweight position on Chinese stocks for the next six months. Most clients shared our concern that policymakers may keep financial and industry regulations more restrictive than the market is currently pricing in, leading to more downside surprises to risk asset prices. Clients also brought up a few opposing views which challenged our analytical framework. In this and next week’s reports we will highlight some of the counterpoints we discussed in these meetings. Interestingly, most of our clients - even ones who are more sanguine about China’s economic outlook - prefer to wait on the sidelines before jumping back into China’s equity market. They foresee sustained volatility in the coming months as the market continues to struggle between digesting high valuations and adjusting expectations for future earnings growth. Has China’s Economic Recovery Reached An Apex? The primary discussion centered around whether the strength in China’s economy has reached a cyclical peak. Q1 GDP points to slower sequential economic momentum from Q4 last year (Chart 1). Some of the high-frequency economic data also indicate that economic activity peaked in Q4 last year (Chart 2).  Chart 1Q1 Sequential Growth Was The Slowest In A Decade Chart 2Has Economic Activity Peaked? Chart 3Our Framework Suggests A Slower Growth Momentum Ahead The view fits perfectly into our analytical framework, which has worked well in the past decade. Historically, China’s credit formation has consistently led economic activity by about six to nine months. A turning point in the credit impulse occurred last October, which suggests that economic activity should start to slow in Q2 this year (Chart 3). However, our clients countered with the following arguments, which support a notion that sequential economic growth rate can still trend higher in the next six months: Aggregate demand in Europe and the US continues to improve, while the COVID-19 resurgence in major emerging economies, such as India and Brazil, has forced their production recoveries to pause. Thus, China’s exports will remain robust and should continue to make substantial contributions to the economy (Chart 4). Infrastructure spending could get a meaningful boost when local governments speed up issuing special-purpose bonds (SPB) in Q2 and Q3. Infrastructure investment growth was relatively weak in Q1, probably the result of a slower pace in credit growth and government expenditures (Chart 5). However, a delay in local government SPB issuance in Q1 this year means more support for infrastructure investment in the rest of the year (Chart 6). Chart 4Counterpoint #1: Chinese Exports Will Stay Strong   Chart 5Slower Credit Growth Led To A Subdued Q1 Infrastructure Investment Growth     Travel restrictions imposed during the Chinese New Year weighed heavily on the service sector in Q1 (Chart 7). If China’s domestic COVID-19 cases remain well controlled, then the trend could reverse and the pent-up demand for service consumption may usher in a significant improvement in Q2 when three major public holidays occur. The service sector accounts for more than half of China’s GDP, therefore, an improvement in this sector should significantly bolster future GDP growth. Chart 6Counterpoint #2: More LG SPBs, More Spending On Infrastructure Chart 7Counterpoint #3: Service Sector Activities Will Pick Up Our Analytical Framework The viewpoints expressed by clients have not changed our cyclical view of China’s economy, since our broad analysis of Chinese business cycle already incorporates the main points that clients raised. Additionally, data such as GDP growth figures are coincident and lagging indicators, and do not explain the direction of forward-looking financial markets. The authorities will shift their policy trajectories only if the data significantly deviate from expectations. We view Q1 GDP and underlying data broadly in line with Chinese leadership’s short- and medium-term economic growth targets and, therefore, will not lead to any policy adjustment. Chart 8If Demand For Chinese Exports Stays Strong, Reform Efforts Will Intensify To our clients’ point that strong exports ahead will support China’s overall GDP growth, we regard a favorable external backdrop as a potential downside risk to the domestic economy. The willingness of Chinese authorities to pursue painful reforms is often positively correlated with global growth (Chart 8). BCA has written extensively about how China has taken advantage of a stronger export sector by increasing the pace of domestic reforms and in the past has embarked on a multi-year reform plan that weighed on growth. At the beginning of this year, Chinese policymakers were set out to “keep credit growth in line with nominal GDP growth in 2021.” Nonetheless, policymakers’ targets for credit and nominal GDP growth rates could change during the year, contingent on their perception of the broad growth outlook and unemployment. Chart 9Both Credit And Economic Growth Rates Are Moving Targets And Subject To Policy Finetuning Even if policymakers keep the country’s leverage ratio steady in 2021, which is our base case view and assuming China’s nominal GDP grows by 11%, then the credit impulse (measured by the 12-month difference in total social financing as a percentage of GDP) will likely fall to about 28% of GDP, down from 32% of GDP in 2020 (Chart 9).  The rate of credit formation increased by 13.6% in the first three months from Q1 last year, above government’s target. We expect a further pullback in credit growth in the rest of the year, to bring the annual pace at or below 12%. Construction capex, which is sensitive to both credit creation and tightening regulations in the housing sector, will likely experience a slowdown. At more than 90% of GDP, China’s economy is mainly driven by domestic demand and a weakening in the domestic economy can more than offset positive contributions from a robust export sector. Infrastructure And Services We expect infrastructure investment will grow by 4-5% this year, which is in line with its rate of expansion in 2020. However, the sequential growth in the sector in Q2 – Q4 this year will be slower than during the same period in 2020 (Chart 10). We agree that a more concentrated issuance of local government SPBs in Q2 and Q3 could help to buttress infrastructure investment. However, SPBs made up only about 15% of overall infrastructure spending in the past three years, so we are dubious that SPBs can provide the crucial support. The rest of the gap for local governments to finance their spending on infrastructure projects will need to be filled through public-private partnerships (PPP) financing, government-managed funds’ (GMFs) revenues, government budgets and bank loans. Note that only non-household medium- and long-term (MLT) bank lending showed a positive impulse so far (Chart 11). While not all of MLT loans are used for infrastructure, they have a positive correlation with investments in infrastructure projects which are generally long term in nature. Chart 10Sequential Growth In Infrastructure Investment Will Be Slower Than In Q2 – Q4 Last Year Chart 11MLT Bank Loans Have Been Supportive To Infrastructure Spending... On the other hand, the contribution of PPPs to total infrastructure spending has been plunging in recent years due to tighter regulations aimed at controlling increased risks related to local government debt (Chart 12). Depressed revenues from land sales and extended corporate tax cuts this year will also curb the ability of local governments to finance infrastructure projects (Chart 13). Chart 12...But Public-Private Partnerships Have Become Too Small To Fill The Financing Gap Chart 13Government-Managed Funds Also Face Headwinds From Falling Land Sales Finally, although the service sector accounts for 54% of China’s GDP (2019 statistic), transport, retail and accommodation, which were hardest hit by COVID-19, accounted for less than 30% of China’s tertiary GDP. This compares with a slightly larger share of tertiary GDP from finance- and housing-related sectors (financial intermediation, leasing & business services, and real estate) –the sectors that have been thriving since the second half of last year when both the equity and housing markets boomed (Chart 14). Nonetheless, it is unreasonable to expect these areas to strengthen even more in an environment where the policy has shifted to contain risks in the financial and housing arenas. The net result to tertiary GDP growth is that the deterioration in finance- and real estate-related segments will likely offset an improvement in transport, retail and accommodation. Chart 14More Than 70% Of China’s Services Sector Is Finance And Real Estate Related Investment Conclusions The ultimate question we got from almost every client meeting was: What would make us turn bullish on Chinese stocks in the next 6 to 12 months?  Chart 15Changes In Domestic Policy Dominate Chinese Stock Performance Since most monthly and quarterly economic data do not provide enough market-moving catalysts, we rely on our assessment of the changes in policy direction, such as interbank liquidity conditions and excess reserves, in addition to overall credit growth (Chart 15). We will also continue to watch for the following signs before upgrading our tactical and cyclical calls from underweight to overweight: Chart 16 shows that cyclical stocks remain depressed relative to defensives in both onshore and offshore markets, underscoring investors’ concerns about China’s economy. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards policy support and economic growth. A technical breakdown in the performance of healthcare and utility stocks relative to investable stocks would be another bullish indicator (Chart 17). These equities have historically led China’s economic activity, core inflation and stock prices by one to three months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a meaningful economic upturn in China.   Chart 16Waiting For A Telltale Sign... Chart 17...Before Upgrading Chinese Stocks   Given that the above mentioned indicators remain firmly in a risk-off mode, we maintain our view that China’s economy has reached its peak, and policy has tightened meaningfully. Our cyclical underweight position on Chinese stocks, in both absolute terms and within a global portfolio, is warranted.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights If fully implemented, President Biden’s Made in America Tax Plan would reduce S&P 500 earnings by about 8%. We expect some of the proposed tax measures to be watered down, resulting in a 5% decline in earnings. Investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy. Looking further out, however, we see four reasons why US tax rates are likely to keep rising, eventually reaching levels that hurt stock prices: First, the effective US corporate tax rate is still very low; second, the failure of President Trump’s tax cuts to boost investment spending will make it easier eventually to fully reverse them; third, rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing; and fourth, and most importantly, the political winds are shifting in favor of higher taxes on corporations and the wealthy. The Democrats have been moving leftward on economic matters for some time. For their part, conservative Republicans are starting to ask themselves why they should support tax cuts for a growing list of “woke” companies that seemingly hate them. The US corporate sector is at risk of being left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. The Biden Tax Plan On March 31st, President Biden unveiled the American Jobs Plan. The plan proposes $2.25 trillion in new federal spending, spread out over eight years, on public infrastructure and other areas. As outlined in the Made In America Tax Plan, the Biden Administration will seek to raise $2 trillion in tax revenue over the next 15 years in order to fund the new spending package. The three most important provisions in the tax plan are: Raising the domestic corporate income tax rate from 21% to 28%. This would bring the tax rate halfway back to where it was prior to the Trump tax cuts (35%). Taking into account the global distribution of corporate profits and other factors, such a tax hike would reduce S&P 500 earnings by about 4%. Increasing the minimum tax on the foreign profits of US companies. The Biden administration proposes doubling the minimum tax rate on Global Intangible Low-Taxed Income (GILTI) from 10.5% to 21%. It also plans to eliminate the Foreign-Derived Intangible Income deduction (FDII). These two measures would reduce S&P 500 earnings by about another 3.5%. A 15% minimum tax on “book income” (i.e., the earnings that companies report to shareholders). The tax applies to corporations with annual profits in excess of $2 billion. The Treasury department estimates that 45 companies will be liable for this tax. It would cut S&P 500 earnings by a further 0.5%. Taken together, these provisions would reduce S&P 500 earnings by about 8%. In practice, we think the impact will be closer to 5%. The Biden plan includes a variety of tax credits, focusing on areas such as clean energy and R&D, which should offset some of the tax increases. The ultimate corporate tax rate is also likely to fall short of 28%. West Virginia Senator Joe Manchin, the critical swing voter, has already said he would prefer to cap it at 25%. What Has Been Priced In? Chart 1Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Our reading of the data suggests that very little of the impact from higher taxes has been baked into either analyst earnings estimates or market expectations. Chart 1 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. Yet, they have outperformed their low-taxed peers since the Georgia runoff election, which handed the Senate to the Democrats. Likewise, earnings estimates have not reacted to the prospect of higher taxes. This is not surprising. Chart 2 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Similar to what happened back then, analysts appear to be waiting for the details of the ultimate tax package before changing their estimates. Chart 2Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes For Now, Business Cycle Dynamics Are More Important Than Taxes While the failure of the investment community to price in higher taxes represents a headwind to stocks, we would characterize it as a modest headwind. IBES estimates still point to earnings growth of 15% for S&P 500 companies in 2022. It would take an unrealistically large tax hit to keep corporate profits from rising next year. The IMF’s latest economic projections, released a few weeks ago, foresee US real GDP growing by 3.5% in 2022, one full percentage point faster than the Fund expected in January (Table 1). Given the strong correlation between equity returns and economic growth, the equity bull market will likely survive a tax increase (Chart 3). Table 1Growth Remains Robust Chart 3Stocks Usually Outperform Bonds When Economic Growth Is Strong   Of course, some stocks could still feel the pinch from higher taxes. The tech sector is especially vulnerable, given that it currently enjoys one of the lowest effective tax rates in the S&P 500 (Chart 4). Tech companies have also been very adept at shifting income from intangible assets such as patents to offshore tax havens, which is likely to put them in the crosshairs of the soon-to-be bulked up IRS.1 We currently favor value over growth stocks. The likelihood that higher taxes will have a disproportionately negative effect on growth sectors such as tech only reinforces this view. Chart 4Tech Is Vulnerable To Higher Taxes   Higher Taxes: Start Of A Long-Term Trend? While we are not too worried about the near-term impact of higher taxes on equity prices, we are more concerned about the longer-term consequences. As we discuss below, not only is Biden likely to raise personal income and capital gains taxes to fund future spending initiatives such as the forthcoming American Families Plan, but the pressure to keep raising business taxes will persist well beyond his administration. There are four reasons for this: Reason #1: The effective US corporate tax rate is still very low Chart 5Corporate Tax Revenues Are Low In April 2018, four months after the Tax Cuts and Jobs Act came into effect, the Congressional Budget Office projected that US corporations would pay $276 billion in corporate taxes in 2019. In the end, they paid only $230 billion.2 US corporate income tax receipts stood at only 1% of GDP in 2018-19, half of what they were in 2013-17 (Chart 5). During Ronald Reagan’s second term in office, US corporations faced an effective tax rate of around 30%. Today, it is less than 15% (Chart 6). As a share of GDP, the US government collects less corporate tax revenue than almost all other OECD economies (Chart 7).   Chart 6The Economy-Wide Effective Corporate Tax Rate Has Been Shrinking For More Than Three Decades Chart 7US Corporate Taxation Is Not High Chart 8Trump Was Unlucky To Be Singled Out By The IRS Moreover, the US government often does not even bother to even collect the money that is owed to it. Audits of corporations with more than $20 billion in assets are down 50% since 2011. Audits of individuals with annual income above $1 million are down 80% (Chart 8). In his testimony to the US Senate this week Chuck Rettig, IRS Commissioner, estimated that tax evasion costs the government $1 trillion per year. Reason #2: The failure of Trump’s tax cuts to boost investment spending will make it easier to eventually fully reverse them If the Trump tax cuts had raised investment spending, it would be easier to overlook the negative effect that they had on the budget deficit. The evidence, however, suggests that lower corporate taxes did very little to spur capex. Chart 9 shows that capital spending barely increased as a share of GDP in the two years following the passage of the Tax Cuts and Jobs Act. According to the International Monetary Fund, only one-fifth of the tax cuts were used to finance capital investment and R&D spending.3 Along the same lines, Hanlon, Hoopes, and Slemrod found that fewer than a quarter of S&P 500 companies discussed plans to increase capex in response to lower taxes during their conference calls.4 Chart 9Trump's Tax Cuts Did Little To Spur Investment Chart 10Business Equipment And IP Do Not Last Long   Why did corporate investment fail to rise much? One answer is that a tax on profits is not the same thing as a tax on capital investment. As Appendix 1 explains, lower corporate taxes are unlikely to have much of an effect on debt-financed capital spending when interest costs are tax deductible. Unlike long-lived assets such as homes, most of the corporate capital stock is fairly short-lived (Chart 10). The demand for business equipment and software depends more on the outlook for aggregate demand than on the cost of capital. Finally, as we explained in a report entitled Inequality Led To QE, Not The Other Way Around, the majority of corporate profits these days can be attributed to monopolistic power of one form or another. Standard economic theory suggests that taxing monopoly rents will not reduce output or investment. Reason #3: Rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing With interest rates still at exceptionally low levels, there is no immediate need to raise taxes to finance increased government spending. This is especially true for infrastructure spending, which can reasonably be expected to boost economic growth (and hence tax receipts) over the long haul. Chart 11US Interest Payments Will Skyrocket Under The Status Quo If interest rates were to rise, however, governments would likely find it advantageous to increase taxes rather than face spiralling debt-servicing costs. Public debt levels are very high in the US and in most other economies, so any increase in interest rates would siphon funds from social programs towards bondholders. This would not be popular with voters. The Congressional Budget Office estimates that federal government interest payments will swell rapidly over the coming decades if measures are not taken to rein in budget deficits (Chart 11). As we discuss next, these measures are likely to take the form of higher taxes rather than spending cuts.   Reason #4: The political winds are shifting in favor of higher taxes on corporations and the wealthy Democrats have been moving leftward for some time. In 2001, 50% of Democrats said that “government should do more to solve our country’s problems.” Today, that number is 83% (Chart 12). Chart 12Democrats Want More Government Chart 13Big Ticket Social And Health Care Spending To Keep Rising While Republicans continue to show a preference for small government, this may not last. Medicare and Social Security consume over 40% of all federal non-interest spending. Outlays on both programs (Medicare in particular) are set to grow rapidly over the coming years (Chart 13). To the extent that the political preferences of older Americans lean Republican, this could make the GOP more inclined to support higher taxes in order to sustain benefits to the elderly. The fact that corporations and the rich increasingly favor socially liberal policies is leading conservative Republicans to ask why they should continue to support tax cuts for people and companies that seemingly hate them. Whereas Joe Biden won the richest US counties by 20 percentage points last November, Trump saw his support rise in the poorest counties (Chart 14). Reflecting this trend, the share of Republicans who expressed “hardly any confidence in Corporate America” rose from 19% in February 2018 to 30% in March 2021 (Chart 15).   Chart 14Democrats Have Made Serious Inroads Among The Better-Off Chart 15Republicans Growing More Skeptical Of Corporate CEOs More than twice as many Republicans now favor raising corporate taxes as lowering them (Chart 16). Nationally, 73% of Americans are dissatisfied with the influence that corporations have over the nation, a 25-point jump from 2001 (Chart 17). Chart 16More Americans Want To Soak The Rich Chart 17Souring Attitudes Toward Big Corporations Given the shift in public opinion, it is not too surprising that the Republican response to Biden‘s tax plan was decidedly “low energy”. After a perfunctory condemnation of the plan, Republican leaders quickly pivoted to attacking “woke” corporations. Addressing the corporate reaction to Georgia’s new election law, Senate Republican Leader Mitch McConnell declared “We are witnessing a coordinated campaign by powerful and wealthy people to mislead and bully the American people.” He went on to say, “From election law to environmentalism to radical social agendas to the Second Amendment, parts of the private sector keep dabbling in behaving like a woke parallel government. Corporations will invite serious consequences if they become a vehicle for far-left mobs to hijack our country from outside the constitutional order.” If current trends continue, as we suspect they will, the US corporate sector will be left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Appendix 1: When Do Higher Taxes On Corporate Profits Reduce Investment? Suppose a company is considering whether to purchase a piece of machinery for $1000. Let us assume that the company faces an external rate of return, r, of 8%. That is to say, it can borrow and lend at 8%. The accompanying table illustrates how the firm’s profits will vary depending on its internal rate of return (the return on investment that the machine will generate). Let us start with the case where the company finances the purchase of the machine by issuing new debt. For now, assume that the internal rate of return is 10% and that the machine can be used indefinitely (i.e., it never depreciates). In this case, the machine will generate $100 in operating income per year. After subtracting the $80 in interest expense, the company will be left with $20 in pre-tax income (Example A). Suppose the company faces an income tax of 20% and interest is fully tax deductible. Then, the company will pay a tax of $20*0.2=$4, leaving it with $16 in after-tax profits (Example B). Notice that while the tax reduced the company’s after-tax profit, it did not extinguish the incentive to purchase the machine in the first place. After all, while $20 is better than $16, $16 is still better than zero. Thus, in this simple example, we see that when the purchase of capital equipment is financed through debt and interest payments are fully tax deductible, the imposition of a profit tax will not affect the ultimate decision of whether to invest or not. Things change when interest is not tax deductible. In this case, the internal rate of return must rise to r/(1-t) to make the company indifferent between buying the machine or not. In the example above, this means the internal rate of return must increase to 8%/(1-0.2)=10%. Then, the company will make an operating profit of $100, pay $20 in tax on that profit, and after paying $80 in interest, end up breaking even (Example C). The calculus in deciding whether to invest in new capital equipment is similar for equity financing as it is for debt financing when interest payments are not tax deductible. The best way to think about equity financing is to ask how much the market price of the machine will be after the company purchases it. If there is no tax and the internal rate of return is 10%, the market price will be $100/0.08=$1250 (Example D). Since the company can buy the machine for $1000, it makes sense to buy it. If the owner of the machine has to pay a profit tax of 20% on the stream of income that it generates, its market value will only be $80/0.08=$1000 (Example E). At this point, the company is indifferent about whether to purchase the machine or not. How do things change when we abandon the assumption that the machine lasts forever? The main difference is that the decision of whether to buy the machine becomes less sensitive to changes in the cost of capital. For example, suppose the machine only lasts one year. To make it worthwhile for the company to purchase that machine, the revenue that it generates in that one year must rise dramatically (Example F). This makes the decision to purchase the machine much less dependent on the interest rate and more dependent on business cycle considerations, especially the outlook for aggregate demand.   Appendix Table 1 Footnotes 1 Jed Graham, “Biden's Tax Plan: What It Means For Amazon, Google, Facebook, Apple, Microsoft,” Investor’s Business Daily (April 8, 2021). 2 “The Accuracy of CBO’s Baseline Estimates for Fiscal Year 2019,” Congressional Budget Office (December 2019). 3 Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “U.S. Investment Since the Tax Cuts and Jobs Act of 2017,” IMF Working Paper (May 31, 2019). 4 Michelle Hanlon, Jeffrey L. Hoopes, and Joel Slemrod, “Tax Reform Made Me Do It!” NBER Working Paper 25283 (November 2018). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear Client, Next week I will be hosting a series of Roundtable discussions with BCA’s clients in both Europe and Asia. Our next report published on April 28th will be a recap of my observations from these meetings. Best regards, Jing Sima China Strategist Highlights The sharp uptick in Chinese producer prices should be transitory, unlikely to trigger a policy response. There are two scenarios under which Chinese manufacturers’ profit margins will benefit: either Chinese exporters will raise export prices and pass input costs onto American customers, or the RMB will depreciate versus the US dollar and commodities prices will experience a setback. The second scenario is more likely in the next 3-6 months. After a pandemic-driven boost in 2020, US imports from China will likely moderate in the second half of 2021 and into 2022. President Biden’s grand infrastructure spending plan, even if approved later this year, will not be a game changer for China’s exports or economy. The strength in the USD may intensify in the near term, and Chinese policymakers will be happy to allow the RMB to depreciate mildly. Stay underweight Chinese stocks. Feature Last week’s China’s producer price index (PPI) was more elevated than the market expected. However, it does not warrant a policy response, given that the increase was mostly driven by supply constraints rather than an overheating domestic economy. Chinese manufacturers have had a tough time passing on mounting input prices to customers, which raises the question about how profit margins will be maintained. For exporters, the answer may be a combination of increasing export prices in USD terms and depreciating the RMB.  The rate of growth in US demand for Chinese export goods may moderate in the second half of 2021 and into 2022 after a pandemic-driven boost in 2020. China’s economic growth and interest rate differentials with the US will continue to narrow in the rest of this year. We expect the RMB to face headwinds against the USD, at least in the next quarter or two. Meanwhile, global investors should continue to underweight Chinese stocks. The PBoC Will Not React To Supply-Side Price Pressures Chart 1Marchs Strong PPI Does Not Reflect An Overheating Domestic Economy Despite above-expectation readings in China’s PPI, the domestic economy shows no signs of overheating. The upside pressure on producer prices reflects the impact of both the global rally in commodities and base effects (Chart 1). In March, strength in the PPI was also accentuated by seasonality due to a resumption in construction and real estate activity following the Chinese New Year holiday. While base effects and global supply bottlenecks will continue to buoy PPI prints throughout Q2, these effects are likely transitory and would not justify a policy response. At 0.4% year-over-year in March, core CPI remains significantly below the central bank’s 3% target and does not indicate any demand-side pressure. Instead, the inability for Chinese producers to pass on higher input prices to consumers highlights the relatively subdued state of domestic demand (Chart 1, bottom panel). Chart 2Current Macro Policy Works To Cap The Upsides In Both The Price And Quantity Of Money At this point there are little signs that rising producer prices are spilling over to consumer prices. We expect Chinese authorities to continue its current policy trajectory, which intends to keep a steady interbank rate while keeping money supply growth at or below the rate of nominal GDP expansion (Chart 2). China’s Deteriorating Terms Of Trade Chinese export prices climbed slightly in USD terms, but not by enough to offset the RMB’s relentless appreciation from the second half of last year, as indicated by falling export prices in RMB terms (Chart 3). A deteriorating terms of trade (ToT), defined as export prices relative to import costs, means that Chinese producers must export a greater number of units to purchase the same number of imports (Chart 4).  The declining ToT can be a powerful deflationary force for China’s manufacturing sector. Chart 3Chinese Export Prices Are Rising In USD Terms But Falling In Local Currency Terms Chart 4Terms Of Trade Have Been Falling Chart 5Chinese Output Prices Lead US Consumer Inflation By A Year While there are limited choices for China to improve its ToT, manufacturers could raise export prices in USD terms and “recycle” cost-push inflation back to the US. Chinese PPI normally leads US consumer inflation by 12 to 18 months (Chart 5). Hence, it is possible that the US will see import prices from China picking up more momentum by the middle of next year. The RMB’s performance is a key macro driver for manufacturing-related output prices. A depreciation in the RMB can be a meaningful reflationary force for manufacturers. There has been a clear negative correlation between the trade-weighted RMB and Chinese manufacturers' output prices and industrial profits, as shown in Chart 6. In this scenario, the USD will continue to appreciate against the RMB and possibly emerging market currencies, a headwind to global trade (Chart 7). Chart 6A Falling RMB Can Be Reflationary To Chinese Producers Chart 7A Stronger USD Will Be Headwinds For Global Trade Maintaining a strong RMB can partly mitigate the pain stemming from escalating commodity import prices.  However, in our view it is the least preferred option by policymakers. In previous cycles a rapidly strengthening RMB did not have a major impact on Chinese exporters' competitiveness, mainly because declines in commodities prices effectively offset a rising RMB (Chart 8 and Chart 9). Therefore, Chinese exporters did not need to boost prices in USD terms to maintain their profit margins. Chart 8RMB Appreciations Did Not Hurt Chinas Share In Global Trade Chart 9...Because Declines In Commodities Prices Were Able To Offset A Rising RMB Bottom Line: Chinese exporters can either raise prices and pass the inflation onto American customers, or the PBoC will allow further depreciation in the RMB to maintain Chinese producers’ competitiveness. Appreciating the RMB is the least preferred option. Don’t Count On A US Buying Spree  Market participants in China are pricing in large windfalls from the US$1.9 trillion American Rescue Plan and proposed US$2.4 trillion American Jobs Plan.1 A positive export tailwind in Q1 this year boosted China’s economic activity beyond what measures of domestic money and credit would have predicted, as shown in Chart 10. However, given the strongly positive relationship between the export sector and real investment in China, it is concerning that any deceleration in US demand for Chinese export goods would seriously challenge the sanguine view for China’s economy this year (Chart 11). Chart 10Export Strength Appears To Be Propping Up The LKI Chart 11China's Export Sector Is Highly Investment-Intensive Moreover, US demand for Chinese export goods is subject to several countervailing forces, at least in the second half of 2021: The USD currently benefits from widening real interest differentials and stronger US growth relative to the rest of the world. For the next quarter or two, persistent strength in the USD and US Treasury yields will be headwinds to global trade and may cause a temporary setback for the global manufacturing sector (Chart 7 on Page 4). Residential and business investment in the US may not regain much vigor despite large stimulus checks. Our colleagues at BCA US Investment Strategy expect US residential investment to match the long-run trend growth, but the increase will be largely offset by below-trend growth in non-residential investment. More working-from-home options will continue to drive demand for single-family homes in the suburbs and beyond. On the other hand, demand will suffer for office space in central business districts and dwellings in urban centers. Brick-and-mortar retail construction is also going to crater. Consumption for goods in the US may also see below-trend growth in the second half of 2021 and into 2022, whereas the service sector will benefit most from the coming recovery in US business and social activities. Table 1 shows that goods spending rose in 2020 despite an overall decline in consumption, because households dramatically shifted their consumption into goods from services. As such, 2020’s pandemic-driven dividend for Chinese exporters is likely to become a drag on tradeable goods exports to the US in 2021 and/or 2022. Table 1US Consumer Spending Gap Is Almost Entirely On The Services Side It is also important for investors to put the US$2.4 trillion infrastructure spending budget proposed in the American Jobs Plan into prospective. The US lags far behind China in infrastructure spending. In the past 10 years, US public infrastructure investment (federal and state combined) has declined to an average of about $450 billion.2 This compares with China’s US $1.9 trillion yearly spending on infrastructure (Chart 12). China currently consumes seven to eight times more industrial metals than the US (Chart 13). As such, even if the US infrastructure investment plan will be approved later this year, it is unlikely to be a game changer for global commodity prices or Chinese exports. Chart 12Infrastructure Spending, China Vs. The US Chart 13US Consumption Of Industrial Metals Is Too Small Relative To China The proposed US$1.2 trillion spending on the US nation’s roads, bridges, green spaces, water, electricity, and universal broadband will be spread over the next eight years.  The additional $150 billion per annum to the US public infrastructure investment will only boost the US spending from 24% to about 32% of China’s annual infrastructure investment. Furthermore, the fiscal multiplier effect from the extra public spending on investment from the US private sector and overall economy may not be as positive as the market has priced in, depending on the size of corporate tax hikes in the final bill. Bottom Line: After a pandemic-driven boost in 2020, growth in US imports from China will likely moderate in the second half of 2021 and into 2022. The proposed infrastructure spending plan in the US will benefit Chinese exports, but the magnitude of the windfall may be disappointing. Investment Implications As discussed in a previous report, rising US bond yields will have a muted effect on their Chinese counterparts. Tightened regulations on the real estate industry and a new round of environmental protection laws in China will continue to suppress the domestic credit demand.  As a result, interest rate differentials between China and the US will continue to narrow. The strength in the USD has not run its course and the RMB will face slight depreciation pressures in Q2 and possibly into Q3. A declining RMB will provide reflationary benefits to China’s industrial profits, but with about a six-month time lag. In the meantime, we recommend global investors to continue underweighting Chinese stocks (Chart 14A and 14B). Chart 14AContinue Underweighting Chinese Stocks Chart 14BContinue Underweighting Chinese Stocks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1According to the OECD, recent US stimulus will boost US GDP growth by almost 3 percentage points in the first full year (from 2021Q2 to 2022Q2). The knock-on effect from the stimulus on other economies is projected to be significant, including a half percentage point addition to China’s GDP during the same period. 2The Congressional Budget Office estimated that combined federal, state and local spending on infrastructure was (in 2019 dollars) $441 billion as of 2017. Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance

Highlights The Biden administration is combining Trumpian nationalism with a renewed push for US innovation in a major infrastructure bill that is highly likely to become law. Populism and Great Power struggle with China and Russia are structural forces that give enormous momentum to this effort. Don’t bet against it. President Biden’s $2.4 trillion infrastructure and green energy plan has a subjective 80% chance of passing into law by the end of the year, as infrastructure is popular and Democrats control Congress. The net deficit increase will range from $700 billion to $1.3 trillion depending on the size of corporate tax hikes in the final bill. The second part of Biden’s plan, the roughly $2 trillion American Families Plan, has a much lower chance of passage – at best 50/50 – as the 2022 midterm elections will loom and fiscal fatigue will set in. While the US infrastructure package is a positive cyclical catalyst, it was largely expected, and the Biden administration still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea. Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability but Taiwan remains the world’s preeminent geopolitical risk. In emerging markets, stay short Russian and Brazilian currency and assets – and continue favoring Indian stocks over Chinese. Feature The “arsenal of democracy” is a phrase that President Franklin Delano Roosevelt used to describe the full might of US government, industry, and labor in assisting the western allies in World War II. The US is reviving this combination of productive forces today, with President Joe Biden’s $4 trillion-plus American Jobs and Families Plan unveiled in Pittsburgh on March 31. The context is once again a global struggle among the Great Powers, albeit not world war (at least not yet … more on that below). The US is reviving its post-WWII pursuit of global liberal hegemony – symbolized by its role, growing once again, as the world’s chief consumer and chief warrior (Chart 1). Biden promoted his plan to build up the US’s infrastructure and social safety net explicitly as a historic and strategic investment – “in 50 years, people are going to look back and say this was the moment that American won the future.”1 It is critical for investors to realize that they are not witnessing another round of COVID-19 fiscal relief. That task is already completed with the Republican spending of 2020 and Biden’s own $1.9 trillion American Rescue Plan Act (ARPA), which together with the vaccine rollout are delivering a jolt to growth (Chart 2). Chart 1America Pursues Hegemony Anew Chart 2Consensus Expects 6.5% US GDP Growth After American Rescue Plan Our own back-of-the-envelope estimates of growth suggest that there is considerable upside risk even under current law (Chart 3). The output gap is also guesstimated here, and it will tighten faster than expected, especially as the service sector revives on economic reopening. Chart 3Back-Of-Envelope: US GDP And Output Gap Show Upside Risk After American Rescue Plan Act (ARPA) A growth overshoot is even more likely considering that the first part of Biden’s proposal, the $2.4 trillion American Jobs Plan consisting mostly of infrastructure and green energy, is highly likely to pass Congress (by July at earliest and December at latest, most likely late fall). Our revised estimates for the US budget deficit show that this bill will add considerably to the deficit in the coming years, peaking in three or four years, thus averting the “fiscal cliff” in 2022-23 and adding to aggregate demand in the years after the short-term COVID-era cash handouts dry up (Chart 4). The net deficit increase will be $700 billion if Biden gets all of his tax hikes and $1.3 trillion if he only gets half of them, according to our sister US Political Strategy. Chart 4US Budget Deficit Will Remain Fat In Coming Years We give Biden’s $2.4 trillion American Jobs Plan an 80% chance of passing through Congress by the end of the year. Infrastructure is broadly popular – as President Trump’s own $2 trillion infrastructure campaign proposal revealed – and Democrats have just enough votes to push it through the Senate via budget reconciliation, which requires zero votes from Republicans. Biden’s political capital is still strong given that his approval rating will stay above 50% as long as Trump is the obvious alternative and the Republicans are deeply divided over their own future (Chart 5).2 The second part of his plan, the $1.95 trillion American Families Plan, is much less likely to pass before the 2022 midterm elections – we would say 50/50 odds at best, if the infrastructure deal passes quickly. Chart 5Biden’s Political Capital Is Sufficient To Pass Another Major Law Of course there are very important differences between Biden’s $2.4 trillion infrastructure plan and the similarly sized proposal that Trump would have unveiled this month had he been re-elected: Biden’s proposal is probably heavier on innovation and research and development, and certainly heavier on unionization and labor regulation, than Trump’s would have been. Biden’s plan integrates infrastructure with sustainability, renewable energy, and climate change initiatives that will help the US catch up with Europe and China on the green front. The plan will consist of direct government spending – rather than government seed money to promote private investment. It will be partially offset by repealing the corporate tax cuts in Trump’s signature Tax Cuts and Jobs Act. Most importantly – from a geopolitical point of view – Biden is making a bid for the US to resume its post-WWII quest for global liberal hegemony. He argued that the US stands at the crossroads of a global choice between “democracies and autocracies” and that rebuilding US infrastructure is ultimately about proving that democracies can create consensus and “deliver for their people.” Autocratic regimes, fairly or not, routinely call attention to the divisiveness of modern party politics in the West and the resulting policy gridlock which produces bad outcomes for many citizens, resulting in greater domestic dysfunction and “chaos.” It is important to note that this bid for hegemony will be more, not less, destabilizing for global politics as it will make the US economy more self-sufficient and insulated from the world. It will intensify the US-China and US-Russia strategic competition while making it more difficult for Biden to conduct bilateral diplomacy with these states given their differences in moral values and frequent human rights violations. What is happening now is the culmination of political shifts that pre-date the pandemic, but were galvanized by the pandemic, and it is of global, geopolitical significance for the coming decade and beyond.3 Biden and the establishment Democrats – embattled by populism on their right and left flanks – are shamelessly coopting President Trump’s “Make America Great Again” nationalism with a larger-than-life, infrastructure-and-manufacturing initiative that emphasizes productivity as well as “Buy American” protectionism. Biden explicitly argued that Americans need to boost innovation to “put us in a position to win the global competition with China in the upcoming years.” At Biden’s first press conference on March 25, he made a similar point about China: So I see stiff competition with China. China has an overall goal, and I don’t criticize them for the goal, but they have an overall goal to become the leading country in the world, the wealthiest country in the world, and the most powerful country in the world. That’s not going to happen on my watch because the United States are going to continue to grow and expand.4 The US trade deficit is set to widen a lot further under this massive domestic buildout. It aims to be the largest government investment program since Dwight Eisenhower’s building of the highways or the Kennedy-Johnson-Nixon space race. But it explicitly aims to diminish China’s role as a supplier of US goods and materials and the US trade deficit already shows evidence of economic divorce (Chart 6). The US is bound to have a larger trade deficit due to its own savings-and-investment imbalances but it has a powerful interest in redistributing this trade deficit to its allies and reducing over-dependency on China, which is itself pursuing strategic self-sufficiency and military modernization in anticipation of an ongoing rivalry this century. Chart 6Biden's Coopts Trump's Trade And Manufacturing Agenda Bottom Line: Biden’s $2.4 trillion American Jobs Plan has an 80% chance of passing Congress later this year with a net increase to the fiscal thrust of between $700 billion and $1.3 trillion, depending on how many and how high the corporate tax hikes. The other $2 trillion social spending part of Biden’s plan has only a 50/50 chance of passage. The infrastructure and green energy rebuild should be understood as a return of Big Government motivated by populism and Great Power competition – it is a geopolitical theme with enormous momentum. The result will be faster US growth and higher inflation expectations, with the upside risk of a productivity boom (or boomlet) from the combination of public and private sector innovation. Investors should not bet against the cyclical bull market even though any increase in long-term potential GDP is speculative. A Fourth Taiwan Strait Crisis And The Cuban Missile Crisis Biden’s American Jobs Plan reserves $50 billion for US semiconductor manufacturing, a vast sum, larger than expectations and far larger than the relatively small public investments that helped revolutionize the US chip industry in the 1980s. But it will take a long time for these investments to pay off in the form of secure and redundant supply chains, while a semiconductor shortage is raging today that is already entangled with the US-China rivalry and tensions over the Taiwan Strait. The risk of a diplomatic or military incident is urgent because the chip shortage exacerbates China’s vulnerabilities at a time when the Biden administration is about to make critical decisions regarding the tightness of new export controls that cut off China’s access to US semiconductor chips, equipment, and parts. If the Biden administration appears to pursue a full-fledged tech blockade, as the Trump administration seemed bent on doing, then China will retaliate economically or militarily. Before going further we should point out that there are still areas of potential US-China cooperation under the Biden administration that could reduce tensions this year (though not over the long run). Biden and Xi Jinping might meet virtually as early as this month to discuss carbon emission reduction targets. Meanwhile China is positioning itself to serve as power-broker on two major foreign policy challenges – Iran and North Korea. Biden expressly seeks Chinese and Russian assistance based on the mutual interest in nuclear non-proliferation. Notably, Beijing’s renewed strategic dealings with Iran over the past month highlight its confidence that Biden does not have the appetite to stick with Trump’s “maximum pressure” but rather will seek to reduce sanctions and restore the 2015 nuclear deal. Hence China will seek to parlay influence over Tehran in exchange for reduced US pressure on its trade and economy (Chart 7). Beijing is making a similar offer on North Korea. Chart 7China Holds The Key To Iran, As With North Korea? Ironically both Iranian and North Korean geopolitical tensions should skyrocket in the short term since high-stakes negotiations are beginning, even though they are ultimately more manageable risks than the mega-risk of US-China conflict over Taiwan. China cannot gain the advanced technology it needs to achieve a strategic breakthrough if the US should impose a total tech blockade, e.g. draconian export controls enforced on US allies. Yet it is highly unlikely to gain the tech by seizing Taiwan, since war would likely destroy the computer chip fabrication plants and provoke global sanctions that would crush its economy. The result is that China is launching a massive campaign of domestic production and indigenous innovation while circumventing US restrictions through cyber and other means. Still, a dangerous strategic asymmetry is looming because the US will retain access to the most advanced computer chips via its alliances and on-shoring, whereas China will remain vulnerable to a tech blockade via Taiwan. This brings us to our chief global geopolitical risk: a US-China showdown in the Taiwan Strait. Highlighting the urgency of the risk, Admiral John Aquilino, the nominee for Commander of the US Indo-Pacific Command, told the Senate Armed Services Committee that China might not wait six years to attack Taiwan: “My opinion is that this problem is much closer to us than most think and we have to take this on.”5 To illustrate the calculus of such a showdown – and our reasons for maintaining an alarmist tone and building up market hedges and safe-haven investments – we turn to game theory. Game theory is not a substitute for empirical analysis but a tool to formalize complex international systems with multiple decision-makers. An obvious yet fair analogy to a US-China-Taiwan crisis is the Cuban missile crisis of 1962.6 The standard construction of the Cuban missile crisis in game theory goes as follows: if the US maintains a blockade and the Soviets withdraw their missiles a compromise is achieved and war is averted; if the US conducts air strikes and the Soviets maintain or use their missiles then war ensues. The payouts to each player are shown in the matrix in Diagram 1. Diagram 1Cuban Missile Crisis, 1962 One concern about this construction is that the payouts may underestimate the costs of war since nuclear arms could be used. We insert a comment into the diagram highlighting that the payouts could be altered to account for nuclear war. Note that this alteration does not change the final outcome: the equilibrium scenario is still US blockade and Soviet withdrawal, which is what happened in reality. If we model a US-China-Taiwan conflict along similar lines, the US takes the role of the Soviet Union while China stands where the US stood in 1962 (Diagram 2). This is a theoretical scenario in which the US offers Taiwan a decisive improvement in its security or offensive military capabilities. However, because of the unique circumstances of the Chinese civil war, in which the victors established the People’s Republic of China in Beijing in 1949 and the defeated forces retreated to Taiwan, China’s regime legitimacy is at stake in any showdown over Taiwan. If Beijing suffered a defeat that secured Taiwan’s independence while degrading Beijing’s regime legitimacy and security, the Chinese regime might not survive the domestic blowback.7 Diagram 2Fourth Taiwan Strait Crisis – What Happens If The US Offers Game-Changing Military Support To Taiwan? Thus we reduce the Chinese payout in the case of American victory. In the top right cell of Diagram 2, the row player’s payout falls from two points (2ppt) in the first diagram to one point (1ppt) in this diagram. This seemingly slight change entirely alters the outcome of the game. Beijing now faces equally bad outcomes in the event of defeat, whereas victory remains preferable to a tie. Therefore as long as China believes that the US will not resort to nuclear weapons to defend Taiwan (a reasonable assessment) then it may make the mistake of opting for military force to ensure victory. Fortunately for global investors the US is not providing Taiwan with game-changing military capabilities, although it is ultimately up to China to decide what threatens its security and the US is in the process of upgrading Taiwan’s defense in an effort to deter Beijing from forceful reunification. Thus the exercise demonstrates why we do not expect immediate war – no game-changer yet – but at the same time it shows why war is much likelier than the consensus holds if the military or political status quo changes in a way that China deems strategically unacceptable. A lower-degree Taiwan crisis should be expected – i.e. one in which the US maintains tech restrictions, offers arms sales or military training that do not upend the military balance, or signs free trade agreements or other significant upgrades to the US-Taiwan relationship.8 We would give a 60% probability to some kind of crisis over the next 12-24 months. The global equity market could at least suffer a 10% correction in a standard geopolitical crisis and it could easily fall 20% if US-China war appears more likely. What would trigger a full-fledged Taiwan war? We would grow even more alarmed if we saw one of three major developments: Chinese internal instability giving rise to a still more aggressive regime; the US providing Taiwan with offensive military capabilities; or Taiwan seeking formal political independence. The first is fairly likely, the second lends itself to miscalculation, and the third is unlikely. But it would only take one or two of these to increase the war risk dramatically. Bottom Line: The Taiwan Strait is still the critical geopolitical risk and Biden’s policy on China is still unclear. Iranian and North Korean tensions will escalate in the short run but the fundamental crisis lies in Taiwan. Since some kind of showdown is likely and war cannot be ruled out we advise clients to accumulate safe-haven assets like the Japanese yen and otherwise not to bet headlong against the US dollar until it loses momentum. Emerging Markets Round-Up In this section we will briefly update some important emerging market themes and views: Chart 8Favor USMCA Over Putin's Russia Russia: US-Russia tensions are escalating in the face of Biden’s reassertion of the US bid for liberal hegemony, which poses a direct threat to Russia’s influence in eastern Europe and the former Soviet Union. Ukraine is expected to see a renewed conflict this spring. The top US and Russian military commanders spoke on the phone for the second time this year after Ukrainian military reports indicated that Russia is amassing forces on the border. We also assign a 50/50 chance that the US will use sanctions to prevent the completion of the NordStream II pipeline from Russia to Germany, an event that would shake up the German election as well as provoke a Russian backlash. The Russian ruble has suffered a long slide since Putin’s invasion of Georgia in 2008 and Crimea in 2014 and the country’s currency and equities have not staged much of a comeback amid the global cyclical upswing and commodity price rally post-COVID. We recommend investors favor the Canadian dollar and Mexican peso as oil plays in the context of American stimulus and persistent Russian geopolitical risk (Chart 8). We also favor developed market European stocks over emerging Europe, which will suffer from renewed US-Russia tensions. Brazil: Brazilian President Jair Bolsonaro’s domestic political troubles are metastasizing as expected – the rally-around-the-flag effect in the face of COVID-19 has faded and his popular approval rating now looks dangerously like President Trump’s did, relative to previous presidents, which is an ominous warning for the “Trump of the South,” who faces an election in October 2022 (Chart 9). The COVID-19 deaths are skyrocketing, with intensive care units reaching critical levels across the country. The president has reshuffling his cabinet, including all three heads of the military in an unprecedented disruption that compounds fears about his willingness to politicize the military.9 Meanwhile the judicial system looks likely (but not certain) to clear former President Luiz Inácio Lula da Silva to run against Bolsonaro for the presidency, a potent threat (Chart 10). Bolsonaro’s three pillars of political viability have cracked under the pandemic: the country remains disorderly, the systemic corruption and the “Car Wash” scandal under the former ruling party are no longer at the center of public focus, and fiscal stimulus has replaced structural reform. Chart 9Brazil: Will ‘Trump Of The South’ Face Trump’s Fate? Our Brazilian GeoRisk Indicator has reached a peak with Bolsonaro’s crisis – and likely breaking of the fiscal spending growth cap put in place at the height of the political crisis in 2016 – while Brazilian equities relative to emerging markets have hit a triple bottom (Chart 11). It is too soon for investors to buy into Brazil given that the political upheaval can get worse before it gets better and a Lula administration is no cure for Brazil’s public debt crisis, though a short-term technical rally is at hand. Chart 10Brazil’s Lula Looks To Be A Contender In 2022? Chart 11Brazil: Policy Risk Peaks, Equities Hit Triple-Bottom Versus EM India: A lot has happened since we last updated our views on India, South Asia, and the broader Indian Ocean basin. Farmer protests broke out in India, forcing Prime Minister Narendra Modi to temporarily suspend his much-needed structural reforms to the agricultural sector, while China-backed military coup broke out in Myanmar, and the US election set up a return to negotiations with Iran and the Taliban in Afghanistan. Perhaps the biggest surprise was the Indo-Pakistani ceasefire, despite boiling tensions over India’s decision to make Jammu and Kashmir a federal union territory. The ceasefire is temporary but it does highlight a changing geopolitical dynamic in the region. India and Pakistan ceased fire along the Line of Control where they have fought many times. The ceasefire does not resolve core problems – Pakistan will not stop supporting militant proxies and India will not grant Kashmir autonomy – but it does show their continued ability to manage the intensity of disputes while dealing with the global pandemic. An earlier sign of coordination occurred after the exchange of air strikes in early 2019, which preceded the Indian election and suggested that India and Pakistan had the ability to control their military encounters. India’s move to revoke the autonomy of Jammu and Kashmir in August 2019, along with various militant operations, created the basis for another major conflict this year. After all, the Kargil war in 1999 followed nuclear weaponization, while the 2008 conflict followed the Mumbai attack. But instead India and Pakistan have agreed to a temporary truce. A major India-Pakistan conflict would be a “black swan” as nobody is expecting it at this point. Not coincidentally, India and China also reduced tensions after the flare-up in their Himalayan territorial disputes in 2020. China may be reducing tensions now that it no longer has to distract its population from Trump and the US election. China is shifting its focus to the Myanmar coup, another area where it hopes to parlay its influence with a Biden administration preoccupied with democracy and human rights. Sino-Indian tensions will resume later, especially as China continues its infrastructure construction at the farthest reaches of its territory for the sake of economic stimulus, internal control, and military logistics. The Biden administration is adopting the Trump administration’s efforts to draw India into a democratic alliance. But more urgently it is trying to withdraw from Afghanistan and cut a deal with Iran, which means it will need Indian and Pakistani cooperation and will want India to play a supportive role. Typically India eschews alliances and it will disapprove of Biden’s paternalism. For both China and Pakistan, making a temporary truce with India discourages it from synching up relations with the US immediately. Still, we expect India to cooperate more closely with the US over time, both on economic and security matters. This includes a beefed up “Quad” (Quadrilateral Security Dialogue) with Japan and Australia, which already have strong economic ties with India. Biden’s attempt to frame US foreign policy as a global restoration of democracy and liberalism will not go very far if he alienates the largest democracy in the world and in Asia. Nor will his attempt to diversify the US economy away from China or counter China’s regional assertiveness. Therefore Biden will have to take a supportive role on US-India ties. We are sticking with our contrarian long India / short China equity trade (Chart 12). India cannot achieve its geopolitical goals without reforming its economy and for that very reason it will redouble its structural reform drive, which is supported by changing voting patterns in favor of accelerating nationwide economic development. India will also receive a tailwind from the US and its allies as they seek to diversify production sources and reduce supply chain dependency on China, at least for health, defense, and tech. Meanwhile China’s government is pursing import substitution, deleveraging, and conflict with its neighbors and the United States. While Chinese equities are much cheaper than Indian equities on a P/E basis, they are not as pricey on a P/B and P/S basis (Chart 13) – and valuation trends can continue under the current macro and geopolitical backdrop. Indian equities are more volatile but from a long-term and geopolitical point of view, India’s moment has arrived. Chart 12Contrarian Trade: Stick To Long India / Short China Bottom Line: Stay long Indian equities relative to Chinese and stay short Russian and Brazilian currencies and assets. These views are based on political and geopolitical themes that will remain relevant over the long run but are also seeing short-term confirmation. Chart 13Indian Stocks Not As Over-Priced On Price-To-Book, Price-To-Sales Investment Takeaways To conclude we want to highlight two investment takeaways. First, while the market has rallied in expectation of the US stimulus package, Biden must now get the package passed. This roller coaster process, combined with the inevitable European recovery once the vaccine rollout gets on its feet (Chart 14), will power an additional rally in cyclicals, value stocks, and commodities. This is true as long as China does not tighten monetary and fiscal policy too abruptly, a risk we have highlighted in previous reports. Chart 14Europe's Vaccination Problem While the US is pursuing “Buy American” provisions within its stimulus package, its growing trade deficit shows that it will be forced to import goods and services to meet its surging demand. This is beneficial for its nearest trade partners, Canada and Mexico, and Europe – as well as China substitutes further afield in some cases. Our European Investment Strategist Mathieu Savary has pointed out the opportunities lurking in Europe at a time when vaccine troubles and lockdowns are clouding the medium-term economic view, which is brightening. He recommends going long the “laggard” sectors and sub-sectors that have not benefited much relative to “leaders” that rallied sharply in the wake of last year’s stimulus, vaccine discovery, and defeat of President Trump (Chart 15). The laggard sectors are primed to outperform on rising US interest rates and decelerating Chinese economy as well (Chart 16). Therefore we recommend going long his basket of Euro Area laggards and short the leaders. Chart 15Europe’s Laggards And Leaders Chart 16Macro Forces Favor The Laggards over the Leaders Chart 17Will OPEC 2.0 Maintain Production Discipline To Keep Oil Supplies Tight? Commodities – especially base metals – will continue to benefit from the global and European reopening as well as the US infrastructure buildout, assuming that China does not shoot its economy in the foot. Our Commodity & Energy Strategy highlights that global oil prices should remain in a $60-$80 per barrel range over the coming years on the back of tight supply/demand balances and ongoing OPEC 2.0 production management (Chart 17). We continue to see upside oil price risks in the first half of the year but downside risks in the second half. The US pursuit of a deal with Iran may trigger sparks initially – i.e. unplanned supply outages – but this will be followed by increased supply from Iran and/or OPEC 2.0 as a deal becomes evident.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 White House, "Remarks by President Biden on the American Jobs Plan," Pittsburgh, Pennsylvania, March 31, 2021, whitehouse.gov. 2 A bipartisan bill is conceivably, barely, since Republicans face pressure to join with such a popular bill, but they cannot accept the corporate tax hikes, unionization, or green boondoggles that will inevitably occur. 3 The pandemic and President Trump’s hands-off attitude toward it helped galvanize this revival of Big Government, but the revival was already well on its way prior to the pandemic. 4 White House, "Remarks by President Biden in Press Conference," March 25, 2021, whitehouse.gov. 5 Again, "the most dangerous concern is that of a military force against Taiwan," though he implied that Beijing would wait until after the February 2022 Winter Olympics before taking action. He requested that the US urgently increase regional military defense. See Senate Armed Services Committee, "Nomination – Aquilino," March 23, 2021, armed-services.senate.gov. 6 At that time the Soviet Union stationed nuclear missiles in Cuba that threatened the US homeland directly and sent a convoy to make the missile installation permanent. The US imposed a blockade. A showdown ensued, at great risk of war, until the Soviets withdrew and the Americans made some compromises regarding missiles in Turkey. 7 Note that this was not the case for the US in 1962: Cuba did not have special significance for the legitimacy of the American republic and the American regime would have survived a defeat in the showdown, although its security would have been greatly compromised. 8 Taiwan is proposing to buy a missile segment enhancement for its Patriot Advanced Capability-3 missile defense system for delivery in 2025, though this is not yet confirmed by the Biden administration. See for example Yimou Lee, "Taiwan To Buy New U.S. Air Defence Missiles To Guard Against China," Reuters, March 31, 2021, reuters.com. 9 See Monica Gugliano, "I Will Intervene! The Day Bolsonaro Decided To Send Troops To The Supreme Court," Folha de São Paulo, August 2020, piaui.folha.uol.com.br.

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

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

Highlights The report from last week’s National People’s Congress (NPC) indicates a gradual pullback in policy support this year. Fiscal thrust will be neutral in 2021, whereas the rate of credit expansion will be slightly lower compared with last year. China’s economy should run on its own momentum in the first half, before slowing to a benign and managed rate. Nonetheless, the risk of policy overtightening is nontrivial and could threaten the cyclical outlook on China’s economy and corporate profits. The recent price correction in Chinese stocks has not yet run its course. Moreover, equity prices in both onshore and offshore markets are breaching their technical resistance. We are downgrading our tactical (0 to 3 months) and cyclical (6 to 12 months) positions on Chinese stocks to underweight relative to global benchmarks. Feature China’s budget and key economic initiatives unveiled at last week’s NPC indicate that policy tightening will be gradual this year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li Keqiang’s work plan presented at the NPC’s annual plenary session in Beijing. However, investors have centered on the government’s plan to have a smaller policy push on growth in its budget compared with last year, fearing that economic and corporate profit rebound will disappoint. The Shanghai Composite Index dropped by 6% during the week when the NPC took place. In our view, the risks of a policy over-tightening in the next six months are high. As such, with this report we are downgrading our cyclical call on Chinese stocks to underweight within a global equity portfolio.      Reading Policy Tea Leaves China's growth trajectory since the middle of 2020 has given the government comfort in staying the course on policy normalization. The question is how much Chinese policymakers are willing to pull back support for the economy this year. Overall, the central government plans a smaller policy push in this year's budget and intends to let the economy run on its own steam. Further policy reflation is not in the cards unless a relapse in the economy threatens job creation. The NPC outlined a growth target “above 6%” for 2021 and did not set a numerical goal for the 14th Five-Year Plan from 2021 to 2025. However, de-emphasizing growth does not mean China has abandoned its GDP targets (Table 1). Indeed, in most years in the past two decades, China’s expansion in GDP has overshot objectives set at the NPC (Chart 1). Our baseline estimate is that real GDP will increase by 8% in 2021. Table 12021 Economic And Policy Targets Chart 1Actual Econ Growth Rates Have Overshot Targets In Most Years   We also maintain our view that the rate of credit expansion will be reduced by 2 to 3 percentage points this year to about 11% annually, which is in line with nominal GDP growth (Chart 2). On the fiscal front, the target for a budget deficit was cut by less than half percentage point compared with last year. When taking into account both the government’s budgetary and fund expenditures, the broad-measure fiscal deficit will probably be around 8% of GDP (about the same as last year), which implies there will not be any fresh fiscal thrust in 2021 (Chart 3) Chart 2Credit Growth Will Decelerate From Last Year Chart 3Neutral Fiscal Thrust The pullback in fiscal impulse is larger than in 2010, 2014, and 2017, following the previous three fiscal expansionary cycles. However, the government's eased budget deficit target this year does not mean government expenditure growth will slow. Government revenues climbed sharply by the end of 2020 and will continue to improve this year (Chart 4). Higher revenues will allow more government spending while keeping the fiscal deficit within its objectives. Chart 4Gov Revenue Is On The mend But Spending Has Yet To Pick Up Chart 5A Small Reduction In ##br##LG Bond Quota Furthermore, the quota for local government special purpose bonds was reduced by only 2% from last year.  It should help to support a steady growth in China’s infrastructure investment (Chart 5). The data from January and February total social financing shows a noticeable improvement in corporate demand for bank loans, as well as the composition of bank loans. Corporate demand for medium- and long-term loans remains on a strong uptrend, which reflects an ongoing recovery in corporate profits and supports an optimistic view on capital investment in the months ahead (Chart 6). Chart 6More Demand For Longer-Term Loans Reflects Better Investment Propensity Bottom Line: The growth and budget targets set at this year’s NPC suggest only a modest pullback in policy support. Downside Risks To The Economy Chart 7Econ Growth Usually Peaks Six To Nine Months After Credit Expansion Rate Slows Despite a relatively dovish tone from the NPC, investors should not be complacent about the risk of a policy-tightening overshoot, which could lead to disappointing economic and profit growth this year.  In most of the previous policy tightening cycles, China’s economic activities remained resilient in the first 6 to 9 months (Chart 7). One exception was 2014, when nominal GDP growth dropped sharply as soon as credit growth slowed. The reason is that Chinese authorities kept a very disciplined fiscal stance and aggressively tightened monetary policy, while allowing the RMB to soft peg to a rising USD. In other words, macroeconomic policies were too restrictive during the 2013/14 cycle. Although messages from the NPC do not suggest that Chinese authorities are on such an aggressive tightening path this year, investors should watch the following signs that could threaten China's cyclical economic health: Policymakers may keep monetary conditions too tight, by allowing the RMB to rise too fast while lifting bank lending and policy rates. Currently rates are maintained at historically low levels, much lower than in previous policy tightening cycles (Chart 8). However, the trade-weighted RMB has appreciated by 6% since its trough in July last year and has returned to its pre US-China trade war level (Chart 9).  The Chairman of China’s Banking and Insurance Regulatory Commission recently signaled that bank lending rates would climb. Although we do not expect the rate to return to its 2014 or 2017 level, China is much more indebted than in previous cycles. Even a small bump in interest rates will place a burden on corporates and local governments’ debt servicing cost, dampening their propensity to invest (Chart 10).  Chart 8Aggressive Rate Hikes Are ##br##Unlikely This Year Chart 9Rising RMB Should Refrain Chinese Policymakers From Further Tightening Monetary Stance Chart 10Chinese Private Sector Has Become Much More Sensitive To Rising Interest Rates Chart 11Bank Lending To Property Sector Has Become Increasingly Restrictive   Policies could become too restrictive in key old-economy industries. Chinese authorities have reiterated their determination to contain price bubbles in the property sector. For the first time since 2017, bank lending to real estate developers grew at a pace far below overall bank loans and continued to trend downward in February this year (Chart 11). Moreover, household mortgage loans have reached their slowest expansion rate since 2013.  At 22% of China’s total bank lending, a sharp setback in the property sector’s loan growth will be a significant drag on total credit and the economy.   A worsened imbalance in supply and demand could lead to too much buildup in industrial inventory. Manufacturing inventories recovered sharply following last year’s massive stimulus and many sectors have surpassed their pre-pandemic levels (Chart 12). Strong external demand helped to boost China’s production and propensity to restock on raw materials. However, both China’s core CPI and producer prices for consumer goods remain in the doldrums, which indicates that domestic final demand has yet to fully recover (Chart 13).  As discussed in last week’s report, reopening the world economy in 2H21 should benefit the service sector more than tradeable goods. China’s inventory buildup, particularly in the upstream industries, could turn excessive when export growth slows and domestic demand fails to pick up the slack. Chart 12How Far Can Chinas Inventory Restocking Cycle Go? Chart 13Final Demand Remains ##br##Weak The service sector could take longer than expected to recuperate, even though China’s domestic COVID-19 situation is under control. China’s services sector has flourished in recent years and accounted for 54% of the nation’s pre-pandemic economic output. However, about half of the service sector output is tied to real estate and financial services. Increasing pressures from tighter policy regulations targeting both the property and online financial service sectors could dampen their support to the economy more than policymakers anticipated. At the same time, wage and household income growth could remain tame by China’s standards (Chart 14).   The NPC’s targeted 7% annual increase in spending for national research and development – far below the 12% annual average reached during the past five years – will not be enough to offset the slowdowns in real estate and financial services (Chart 15). Chart 14Household Income Growth Has Yet To Recover Chart 15Chinas Pace Of R&D Investment Has Slowed Along With Econ Growth Bottom Line: The downside risks to China’s cyclical growth trajectory are nontrivial. A tug-of-war between policy tightening and growth support will likely persist throughout this year. Investment Implications We recommend investors to underweight Chinese stocks within a global equity portfolio, in the next 0 to 9 months (Chart 16A and 16B). Chart 16AChinese Stocks Are At Their Technical Resistance Chart 16BChinese Stocks Are At Their Technical Resistance On January 13, we tactically downgraded Chinese stocks from overweight to neutral, anticipating that China’s equity markets are sensitive to rising expectations of policy tightening, due to higher corporate debt-servicing costs and lofty valuations.  Chinese stock prices peaked in mid-February, but in our view the correction has not yet run its course. In terms of the economy, we maintain our baseline view that China's overall policy environment this year will be more accommodative than in 2017/18. The growth momentum carried over from last year's stimulus should prevent China's economy and corporate profits from slumping by too much this year. However, as policy supports are scaled back, investors will increasingly focus on the intensity of China’s domestic policy tightening and the uncertainties surrounding it. Downside risks are nontrivial and will continue to weigh on investors' sentiment. For investors that are mainly exposed to the Chinese domestic equity market, the near-term setbacks in the A-share market are taking some air out of Chinese equities' frothy valuations, and may pave the way for a more optimistic cyclical outlook beyond the next 9 to 12 months. We recommend domestic investors to stay on the sidelines for now, but will start recommending sector rotations in the next few months when opportunities arise. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations