India

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

Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week).   EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth.  Demand in DM economies will fall 3% this year vs 2019 levels.  Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA.  Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA.  As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1  Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts.   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy.  Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9   Footnotes 1     Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 2     Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3    Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion.  It is available at ces.bcaresearch.com. 4    We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5    Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6    Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7     Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8    Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside. Widespread optimism about the outlook for economic activity and earnings over the coming year has led some investors to ask whether an imminent peak in the rate of growth could be a potentially negative inflection point for richly valued risky asset prices. Using our global leading economic indicator as a guide, we find that a peak in growth momentum in and of itself is not likely to be enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). We can identify several candidates for such a shock, including the emergence of new, vaccine-resistant variants of COVID-19, the impact of higher taxes on earnings, overtightening in China, and a potentially hawkish shift in monetary policy in the developed world. But none of these risks individually appears to be likely enough to warrant reducing cyclical portfolio exposure. We continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We remain overweight global ex-US equities vs. the US, but expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials. Within a fixed-income portfolio, we recommend a modestly short duration stance, but do so primarily on a risk-adjusted basis. Feature Chart I-1Europe Is Behind The US, But On The Same Path Over the past month, developed economies have continued to transition towards a post-pandemic state. While the number of new confirmed COVID-19 cases remains relatively high on a per capita basis in the US and Europe, there continues to be significant progress on the vaccination front in all Western advanced economies. Europe continues to lag the US and the UK in terms of the share of the population that has received at least one dose of vaccine, but Chart I-1 highlights that the gap has remained constant at approximately six weeks (to the US). Panel 2 of Chart I-1 highlights that the US and UK both experienced either falling or a stable number of new cases once the number of first doses reached current European levels; Israel required significant further gains in the breadth of vaccinations before it altered COVID-19’s transmission dynamics in that country, but this appears to have occurred because of a much higher pace of spread earlier this year. The negative impact on advanced economies from reduced services activity is strongly linked to pandemic control measures (such as stay-at-home orders, curfews, forced business closures, etc). We have argued that, outside of the US, the implementation and removal of these measures is being driven by the impact of the pandemic on the medical system, rather than the sheer number of new cases and deaths. Chart I-2 highlights that, based on this framework, Europe still has further to go – current per capita hospitalizations remain much higher in France and Italy than in the US, UK, or Canada. But the nature of the disease means that hospitalizations begin to fall even if case counts remain relatively stable, and fall rapidly once new cases trend lower. Given the steady gains that European countries are making in providing first vaccine doses to their populations, it seems likely that hospitalizations there will peak sometime in the coming four to six weeks. This underscores that Europe is not on a different path than that of the US, it is simply further behind in the process (and will ultimately catch up). The transition towards a post-pandemic state is also reflected in the global macro data, which continues to positively surprise in all three major economies (Chart I-3). In Europe, the April services PMI rose back above the 50 mark, April consumer confidence surprised to the upside, and February retail sales came in better than expected (Table I-1). In the US, the March services PMI was also very strong, the labor market continued to meaningfully improve, and several measures of inflation surprised to the upside. Chart I-2Euro Area Hospitalizations Remain High, But Will Soon Decline Chart I-3The Macro Data Continues To Positively Surprise   Table I-1Services PMIs And The Labor Market Continue To Meaningfully Improve Chart I-4China's Current Contribution To Global Demand Is Strong In China, the recent tick higher in the surprise index likely reflects the recognition of some data series whose release was delayed due to the Chinese New Year, as well as significant base effects (compared with Q1 2020) in many data series recorded in year-over-year terms. On a quarter-over-quarter basis, Chinese economic activity decelerated last quarter to 0.6% from the upwardly revised 3.2% in Q4 2020 – which was below the anticipated 1.4% q/q. Still, Chinese RMB-denominated import growth closely matches (lagging) data on global exports to China (in US$ terms), with the former suggesting that China’s current contribution to global external demand remains strong (Chart I-4). This is also consistent with rising producer prices, which had fallen back into deflationary territory last year (panel 2). Peaking Growth Momentum: Should Investors Be Worried? The continued increase in the number of vaccine doses administered, positive data surprises, and bullish global growth forecasts for this year have understandably led to extremely optimistic investor sentiment. It has also naturally raised the question of “what could go wrong?”, with some investors pointing to an imminent peak in the rate of growth as a potentially negative inflection point for richly valued risky asset prices. Chart I-5 addresses this question by examining 12 episodes of waning growth momentum since 1990, defined as an identifiable peak in our global leading economic indicator. Panel 2 shows the 12-month rate of change in the relative performance of global equities versus a US$-hedged 7-10 year global Treasury index. Chart I-5Is Peaking Growth Momentum A Risk For Stocks? At first blush, the chart does support the notion that a peak in growth momentum is generally negative for risky asset prices. The subsequent 12-month relative return from stocks versus bonds following a peak in the LEI has been negative in 8 out of the 12 episodes, suggesting that the risks of an equity correction are currently quite elevated. However, there is more to the story than this simple calculation implies (Table I-2). First, two of the twelve episodes saw the global LEI peak in the context of an eventual US recession, so it is not surprising that stocks underperformed bonds in those episodes. Second, out of the six non-recessionary episodes, only two of them involved significant underperformance, in 2002 and in 2015. Table I-2Peak Growth Momentum Is An Insufficient Catalyst For Equity Underperformance US equities underperformed in the former case because of the persistently damaging impact of corporate excesses that built up during the dot-com bubble, and predominantly global ex-US equities underperformed bonds in the latter case because of a combination of the significant impact on global CAPEX from the 2014 dollar and oil price shock, as well as a major decline in global bond yields. In the four other non-recessionary examples of equity underperformance, stocks only modestly underperformed bonds, and often this occurred in the context of significant events: surprising Fed hawkishness in 1994, the Asian financial crisis in 1997, a major slowdown in China in 2013, and the combination of a domestically-driven Chinese economic slowdown coupled with the Sino/US trade war in 2017/2018. The key point for investors is that a peak in growth momentum is in and of itself not enough of a catalyst for meaningful risky asset underperformance versus government bonds. A sizeable shock to sentiment would likely be required, causing either a very serious growth slowdown, outright fears of recession, or some other event that negatively impacts earnings growth or raises the equity risk premium (“ERP”). What Else Could Go Wrong? There are four other plausible risks that we can identify to a bullish stance towards risky assets over the coming 6-12 months. We discuss each of these risks below. New COVID-19 Variants Chart I-6 highlights that bottom up analysts expect global earnings per share to be 12% higher than their pre-pandemic level in 12-months’ time. This expectation is driven by extraordinarily easy fiscal and monetary policy, but also the view that vaccination against COVID-19 will allow social distancing policies to end and services activity to fully recover. However, as India is clearly – and tragically – demonstrating at present, the emerging world is lagging in terms of vaccinating its population. India’s per capita case count has soared (Chart I-7), which is surprising given that the country’s COVID-19 infection rate has been significantly below that of more advanced economies over the past year. It is therefore likely that India’s case count explosion is due to new variants of the disease, and periodic outbreaks in less developed countries – as well as vaccine hesitancy in more developed economies – risks the emergence of even newer variants that may be partially or substantially vaccine-resistant. Chart I-6Earnings Expectations Already Price In A Normalization In Services Activity Chart I-7India's COVID-19 Situation Is Tragic, And Concerning   New variants of COVID-19 may prove to be less deadly, but the economic impact of the pandemic has come mainly from its potential to collapse the medical system via high rates of serious illness requiring hospitalization, not strictly from its lethality. As such, potentially new vaccine-resistant variants of the disease resulting in similar or higher rates of hospitalization pose a risk to a bullish economic outlook. Taxation Both corporate and individual tax rates are set to rise in the US over the coming 12-18 months which, at first blush, could certainly qualify as a non-recessionary event that negatively impacts earnings or raises the ERP. Corporate taxes are set to rise first as part of the American Jobs Plan, which our political strategists have argued will probably take the Biden administration most of this year to pass. The plan involves a proposed increase in the domestic corporate income tax rate to 28% from 21%, a higher minimum tax on foreign profits, and a 15% minimum tax on “book income”. In addition, as part of the American Families Plan, Biden is proposing to increase the top marginal income tax rate for households earning $400,000 or more to 39.6% (from 37%), and to substantially increase the capital gains tax rate for those earning $1 million or more from a base rate of 20% to 39.6%. The 3.8% tax on investment income that funds Obamacare would be kept in place, which would bring the total capital gain tax rate to 43.4% for that income group. Peter Berezin, BCA’s Chief Global Strategist, made two points about higher corporate taxes in a recent report.1 First, he noted that the changes would likely result in an 8% decline in forward earnings if passed as currently proposed, but that various tax credits as well as opposition to a 28% corporate tax rate from Democratic Senator Joe Manchin would likely cap the impact at 5%. Second, he argued that the behavior of 12-month forward earnings and the performance of stocks that benefitted the most from President Trump’s corporate tax cuts suggest that very little impact from these changes has been priced in. Peter argued in his report that the effect of strong economic growth will likely offset the negative impact of higher taxes on earnings, and we are inclined to agree. Chart I-8 highlights that a 5% reduction in 12-month forward earnings would reduce the equity risk premium by roughly 20-25 basis points, which would not be disastrous on its own. Still, the fact that these changes have not been priced in means that corporate tax hikes could be a more meaningful driver of lower stock prices if the impact is ultimately larger than we currently expect or if the growth outlook suddenly shifts in a negative direction. In terms of changes to individual taxes, our sense is that the proposed increase in the capital gains tax rate is more significant than the modest proposed change to the top marginal income tax rate for higher-income households. For individuals earning $1 million or more, Chart I-9 highlights that the proposed change to the capital gains rate would bring it to the highest level seen since the late 1970s. Given the rich valuation of equities, it seems inconceivable that such a change would not trigger some short-term selling of equities to lock in long-term gains at lower tax rates. Chart I-8Higher Corporate Taxes Will Only Modestly Reduce the Equity Risk Premium Chart I-9Biden's Capital Gains Tax Proposal Would Lead To Some Selling Of Stocks...   But like upcoming changes to corporate taxes, we see the potential for higher taxes on wealthy individuals as a risk to the equity market and not as a likely driver of stock prices over a cyclical time horizon. First, our political strategists see 50/50 odds that the American Families Plan will be passed this year, meaning that short-term tax avoidance selling may be postponed until 2022. In addition, Chart I-10 highlights that over the longer term, the relationship between the maximum capital gains tax rate and the ERP is weak or nonexistent. The chart highlights that the perception of a positive relationship rests entirely on the second half of the 1970s, when the maximum capital gains tax rate was between 30-40%. However, it seems clear from the chart that the stagflationary environment of that period was responsible for a high ERP, as the capital gains rate fell from 1977 to 1982 without any significant decline in risk premia. It took until the end of the 1982 recession and the beginning of the structural disinflationary period for the equity risk premium to decline, suggesting that there is effectively no relationship between the two (and therefore no reason to believe that higher capital gains taxes will lead to sustained declines in stock market multiples). Chart I-10…But The Effect Would Not Likely Last Overtightening In China Chart I-11Leading Indicators Of China's Economy Are Pointing Down, Not Up Even though Chart I-4 highlighted that Chinese import demand is currently strong, we expect China’s growth impulse to weaken in the second half of the year. Chart I-11 highlights that our leading indicator for China’s Li Keqiang index has done a good job of predicting Chinese import growth, and the indicator is now in a clear downtrend. Panel 2 presents the components of the indicator, and shows that all three are trending lower. Monetary conditions are potentially rebounding from extremely weak levels (due to past deflation and a rise in the RMB versus the US dollar and other Asian currencies), but money supply and credit measures are deteriorating. Leading indicators for China’s economy are deteriorating because Chinese policymakers have already tightened liquidity conditions in response to the country’s rebound from the pandemic and following a surge in the credit impulse. The 3-month repo rate returned to pre-pandemic levels in the second half of last year (Chart I-12), and consequently the private sector credit impulse (particularly that of corporate bond issuance) fell despite robust medium-to-long term loan growth. Chart I-12Chinese Interest Rates Have Already Returned To Pre-COVID Levels We noted in our January report that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private sector leveraging. Our base case view is that policymakers will not accidentally overtighten the economy, and that the credit impulse will settle somewhere between late 2019 levels and the peak rate reached in the latter half of last year. But the risk of significant oversteering cannot be ruled out, and will likely remain a downcycle risk for investors for several years to come. A Hawkish Shift In Monetary Policy In Developed Markets Last week the Bank of Canada announced that it would taper its pace of government debt purchases from 4 billion to 3 billion CAD per week. The announcement was noteworthy for many investors, as it suggested that asset purchase reductions could also be announced by the Fed and other major central banks by the end of the second or third quarter. Many investors are sensitive to the tapering question because of what transpired during the “Taper Tantrum” episode of 2013. During an appearance before Congress in late May of that year, then Chair Ben Bernanke stated that the Fed could “step down” the pace of its asset purchases in the next few FOMC meetings if economic conditions continued to improve. The result was that 10-year Treasurys fell roughly 10% in total return terms over the subsequent three-month period. While stocks rallied in response to the growth-positive implications of the move, this occurred from a much higher ERP starting point than exists today. The risk, in the minds of some investors, is that tapering today could thus lead to a correction in stock prices. There are two counterpoints to this view. First, bonds have already sold off meaningfully over the past several months in response to a significant improvement in the economic outlook, and investors already expect the Fed to raise interest rates earlier than it is publicly forecasting. It is thus difficult to see how an announcement of tapering from the Fed would significantly alter the outlook for monetary policy over the coming 6-18 months. Chart I-13Another Taper Tantrum-Like Selloff Would Necessitate Higher Expectations For R-star Second, it is notable that the “Taper Tantrum” began at yield levels at the front end of the curve that are roughly similar to what prevails today. 5-year/5-year forward bond yields stood at roughly 3% at the beginning of the “Tantrum”, compared with 2.3% today. Chart I-13 highlights how high forward bond yields would need to rise in order to generate another selloff of similar magnitude from 10-year Treasury yields (roughly 3.65%). In our view, a rise to this level over the coming year is essentially impossible without a major shift in investor expectations about the natural rate of interest. We highlighted the risk of such a shift in last month’s report,2 but for now it would likely necessitate hard evidence of little-to-no permanent damage to the labor market from the pandemic. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions As noted above, there are several identifiable risks to a bullish outlook for risky assets, but none of these risks individually appear to be likely. Given this, we continue to expect positive absolute single-digit returns from stocks over the coming 6-12 months, and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio. We favor value versus growth stocks, cyclical versus defensive sectors, and small versus large cap stocks, although there is more return potential over the coming year in value versus growth than the latter two positions. We also remain short the US dollar over a cyclical time horizon. Within a global equity portfolio, we remain overweight global ex-US equities vs the US, but this position has moved against us over the past two months. Chart I-14 highlights that global ex-US equities have given back all of their October – January gains versus US equities, most of which has occurred since late-February. The chart also highlights that all of this underperformance has been driven by emerging market stocks, as euro area equity performance has been mostly stable year-to-date. Chart I-15 highlights that EM underperformance has occurred both in the broadly-defined tech sector as well as when measured in ex-tech terms. To us, this suggests that EM stocks are responding to the deterioration in leading indicators for the Chinese economy that we noted above, which implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. Chart I-14Emerging Markets Have Caused Global Ex-US Stocks To Underperform Chart I-15EM's Underperformance Has Been Broad-Based   As a final point, investors should note that we are recommending a modestly short duration stance within a fixed-income portfolio, but that we make this recommendation primarily on a risk-adjusted basis. Chart I-16 highlights that Treasury market excess returns (relative to cash) have historically been driven by whether the Fed funds rate increases by more or less than what is currently priced into the market. Over the past 12 months, the Treasury index has very substantially underperformed cash without a hawkish surprise, and the rate path that is currently implied by the OIS curve is already more hawkish than the Fed is (for now) projecting. On this basis, a neutral duration stance could be justified, but we would still prefer a modestly short duration stance due to the risk of a potential increase in investor expectations for the neutral rate of interest late this year or in early 2022. Chart I-16Policy Rate Surprises Tend To Drive The Duration Call Jonathan LaBerge, CFA Vice President The Bank Credit Analyst April 29, 2021 Next Report: May 27, 2021   II. In COVID’s Wake: Government Debt And The Path Of Interest Rates The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,3 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP4 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.5 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,3 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.6 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record. Within a global equity portfolio, EM stocks have dragged down global ex-US performance, likely in response to deteriorating leading indicators for the Chinese economy. This implies that they are not likely to lead global ex-US equity performance higher over the course of the year barring an imminent shift in Chinese policy. We continue to expect that euro area stocks will have to do the heavy lifting, driven either by the underperformance of global technology stocks or the outperformance of euro area financials – which are extremely cheap relative to US banks and have much further scope for earnings to normalize as the pandemic draws to a close. The US 10-Year Treasury yield has edged lower over the past month, after having risen to levels that were extremely technically stretched. Despite this pause, our valuation index highlights that bonds are still expensive, and that yields could move higher over the cyclical investment horizon. We expect the rise to be more modest than our valuation index would imply, but we would still recommend a modestly short duration stance within a fixed-income portfolio. Commodity prices, particularly copper, lumber, and agricultural commodities, are screaming higher. This reflects bullish cyclical conditions, but also pandemic-induced supply shortages that are likely to wane later this year. Commodity prices are technically extended and sentiment is extremely bullish for most commodities, suggesting that a breather in commodity prices is likely at some point over the coming several months. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. Our global LEI diffusion index has declined significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is lagging). Strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Global Investment Strategy "Taxing Woke Capital," dated April 16, 2021, available at gis.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 3 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 4 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 5 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 6 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Surging Covid-19 cases to unprecedented levels have unsettled India’s equity and currency markets. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential ongoing super-spreader events. Yet, the country’s medium- and longer-term outlooks remain positive. Asset allocators with less tolerance for volatility may tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Feature New COVID-19 cases in India have skyrocketed in the past few weeks – far surpassing previous peaks. The country now accounts for 40% of daily new cases globally (Charts 1 and 2). This has raised the possibility of fresh lockdowns and, as a result, Indian stocks and the currency have begun to sell off. Chart 1Daily COVID-19 Cases Have Lately Skyrocketed In India … Chart 2… Accounting For 40% Of Global Cases And 20% Of Deaths … We have been overweight India in an EM equity portfolio because of the country’s positive cyclical and structural outlook. Even though our views have not changed, we believe the parabolic surge in COVID-19 cases is likely to cause near-term volatility in Indian equity and currency markets. As such, we recommend that asset allocators who have less tolerance for volatility tactically downgrade Indian equities to neutral for the next couple of months. Below we elaborate the reasons for this near-term downgrade, as well as the reasons for our more upbeat view over the medium to long term. New Cases Might Stay High Chart 3… And Raising The Specter Of Another Stringent Lockdown Being a densely populated country with less than ideal living conditions, the attempts to control the spread of COVID-19 via social distancing measures is extremely difficult in India. Yet, the authorities tried to do exactly that last spring by imposing the most stringent lockdown measures anywhere in the world (Chart 3). The result was a complete collapse in economic activity: year-over-year industrial production fell by a half, and GDP contracted by 22% in the second quarter of 2020 from a year ago. Now facing an unprecedented surge in new cases, markets are apprehensive that even a partial lockdown will scuttle the nascent recovery in the economy. Worryingly, the number of new cases in India might stay exceptionally high for a while. The reason is that there are several potential super-spreader events going on. The country is undergoing state-level elections in five states where the candidates are canvassing in front of gatherings of tens of thousands of people. Currently, there is also a religious congregation taking place where up to three million pilgrims have assembled. Chart 4Should Morbidity And Mortality Rates Rise, A Harsh Lockdown May Become Inevitable The morbidity and mortality rates have not yet risen (Chart 4). This is a key metric and will likely determine the stringency of the authorities’ lockdown measures. Even though the Prime Minister has declared that stern lockdowns would be last-resort measures, the possibility cannot be excluded if hospitalization and mortality rates begin to rise. The following has also added to investor concerns: The fact that equity valuations are much higher now than they were last spring makes the market even more prone to a setback (Chart 5). Indian stocks have benefitted from a record amount of foreign portfolio inflows over the past 12 months – totaling $ 34 billion. The risk is therefore high that some of these flows might reverse in the near term if the threat of renewed lockdowns is realized. That will be a headwind for both stock market and the rupee (Chart 6). Finally, a rising US dollar, and a likely general underperformance of EM stocks over the next several months, will also encourage outflows from India. Chart 5Elevated Valuations Have Added To The Vulnerability Of Indian Stocks Chart 6A Reversal In Foreign Portfolio Inflows Will Cause Both Stocks And The Rupee To Fall Cyclical Outlook Remains Positive Beyond the near-term jitters, India’s cyclical outlook remains positive. The recovery has been solid as indicated by the following metrics: The number of E-way bills issued (a barometer of business activity) as part of the Goods & Services Tax (GST) collection mechanism keeps rising steadily. GST collection itself has also been strong – validating the same message (Chart 7). Manufacturing and Services PMIs printed over 55 in March – indicating robust expansion of activity. Order books of companies, as indicated by both RBI and Dun & Bradstreet surveys, look strong. These indicators herald an improvement in industrial production going forward (Chart 8). Chart 7Underlying Economic Recovery In India Has Been Robust So Far … Chart 8… Supported By Strong Order Books … In short, all of the above points to an ameliorating top lines (sales) for the corporates in the coming months, barring stringent lockdowns. Meanwhile, firms’ profits margins have also recovered meaningfully. An RBI survey of over 2600 companies shows that both gross and net profit margins had risen to above pre-pandemic levels by December 2020 (Chart 9). Given the wide margins, a recovery in sales levels will lead to accelerating profits in the quarters ahead. In a sign that profit re-acceleration is not far off, firms have begun to invest in new plants and machinery. Capital spending had already turned positive during the last quarter of 2020 versus the same period of 2019. Imports of capital goods have also begun to rise – corroborating new capex plans of the firms (Chart 10). Chart 9… And Healthy Profit Margins … Chart 10… Which Have Encouraged Firms To Resume Capital Spending New capital expenditure is undertaken only when firms are confident of strengthening demand. Besides, capex usually comes on the heels of rising profits. Higher capital goods imports and capital spending therefore indicate that the companies are optimistic of both sales and profits going forward. On its part, the central bank has ensured that the liquidity in the banking system remains abundant by engaging in plenty of open market operations. Bank credit growth, at 6.3%, is still low, but appears to have bottomed. Excluding the credit to large corporations – who have in recent years been replacing bank credit by local currency debt issuances – the credit growth rate is 9% (Chart 11). Odds are that beyond the near-term jitters due to rising COVID-19 cases, credit will accelerate in line with recovering economic activity. That will be bullish for bank stocks. Incidentally, banks make up the largest chunk of Indian equity index. Finally, Indian small caps continue to outperform their large cap counterparts (Chart 12). Smaller firms in India are much more vulnerable to a slowdown in growth and tighter credit conditions. The fact that they keep outperforming suggests that investors do not expect a major or lasting impact of the latest pandemic outbreak on the economy. Chart 11Bank Credit Will Rise As The Expansion Continues Chart 12Small Caps Outperformance Suggest Investors Are Sanguine About Growth And Credit Conditions Beyond the cyclical recovery, we are bullish on India’s longer-term outlook as well. The reason for that is India is one of the rare EM countries undertaking meaningful structural reforms. The country’s demographics are also highly favorable. We will elaborate on these and other structural issues in greater detail in our future reports. Investment Conclusions Indian stocks and the currency have entered a period of turbulence as surging COVID-19 cases prompt profit taking/selling. EM equity portfolios with low tolerance for volatility should therefore consider tactically downgrading this bourse to neutral for a couple of months. Absolute return investors (in US$ terms) should also brace for near-term volatility in Indian share prices. Over the medium-to-long term however, Indian stocks will likely outperform their EM peers as well as rally in absolute terms (Chart 13). Indian bank stocks are also suffering from the ongoing volatility. However, given Indian private banks’ higher efficiency and better balance sheets vis-à-vis banks elsewhere in the EM, long-term investors should continue to stick with our recommended trade of long Indian banks/ short EM banks (Chart 14). Chart 13Beyond The Near-Term Volatility, Indian Stocks Will Outperform Their EM Peers … Chart 14… So Will Indian Bank Stocks Vis-à-vis EM Banks Fixed income investors should continue receiving 10-year swap rates in India. With the abundant rainfall, food prices will decline. This will keep inflation under check. The rising COVID-19 cases and a potential lockdown are disinflationary in nature and will push down swap rates.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   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 Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes 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.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

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