Emerging Markets

Highlights Our base case reflects our view that China’s strong fiscal and monetary stimulus, combined with a weaker US dollar, will provide a favorable backdrop for copper markets in 2H20. Supply factors are for the most part reflected in current copper prices. In 2H20, the speed of the demand recovery will be the determining factor for prices. Global policy uncertainty remains high.  Assessing the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted will keep uncertainty at relatively high levels.  A possible second wave of COVID-19 returning large economies to lockdown status looms large for copper markets, and for commodity markets generally. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines could keep the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin. Tactically, we remain on the sidelines until the fog clears around these known and unknown unknowns.  A $3/lb COMEX refined copper price is likely in 2H20, but the risks to this outlook remain high. Feature Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Assessing the synchronicity of EM recoveries and the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted is extremely difficult. Looming over all of these considerations: A possible second wave of COVID-19 returning large economies to lockdown status loom large. Tactically, we remain on the sidelines as the fog clears around some of these known and unknown unknowns. Importantly, our positive view rests on our expectation of a robust recovery in China’s economic activity and, to a lesser extent, in its main export destinations, which were hit later by the pandemic. A weak recovery in China would slow the rate at which the current copper supply surplus subsides. At ~ $2.50/lb, copper prices have recovered significantly since bottoming in March at $2.11/lb on the COMEX. Still, clearing the $3.30/lb double top reached in June 2018 will require either a significant increase in global demand or a sharp contraction in supply, which we do not expect. Copper markets were severely hit by the global pandemic: Prices fell 10% in January, as the case count grew in China – the largest copper-consuming market – followed by another 19% decline as the virus spread globally (Chart of the Week). The intensification of lockdowns globally pushed copper markets to a 60k MT surplus as of March – the latest data reported by the World Bureau of Metal Statistics (WBMS) – from a 20k MT deficit in 2019. Bearish sentiment moved our Tactical Composite Indicator – which captures sentiment, positioning, and momentum dynamics – to oversold territories on in March (Chart 2). Chart of the WeekCopper Prices Were Severely Hit By The Pandemic Chart 2Bearish Sentiment Crushes Copper Prices After reaching a low of $2.11/lb on March 23, COMEX copper prices surged 18% with few interruptions as the Chinese economy reopened, and global monetary and fiscal authorities supplied unprecedented economic support (Chart 3). This prompted a wave of short-covering by money managers, releasing some of the downward pressure on prices (Chart 4). Chart 3Unprecedented Fiscal Response Chart 4Money Managers Neutral For Now Still, hedge funds have not yet entered bullish positions on the metal. And, importantly, inventory levels are not drawing sharply. China’s Economy Bottomed, World ex-China Still Contracting Our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. Since the end of the Global Financial Crisis (GFC), copper prices have mostly shadowed China’s economic cycles (Chart 5). China’s importance for copper markets now dominates that of major DM countries (Chart 5, panel 3). The influence of global supply-demand fundamentals on copper prices has declined. Prices are increasingly policy-driven with supply adjusting to demand as dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in that economy. Thus, our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. According to the International Copper Study Group (ICSG), around 17% of Chinese copper demand comes from exports of products containing copper.1 In “normal” times, we rely heavily on our monthly indicators to gauge economic and commodity cycles. However, the speed with which the COVID-19 pandemic evolves – and the associated fiscal and monetary responses to it – makes short-term forecasting of cyclical commodities a perilous task. Chart 5DM Consumption Pales Vs. China High-frequency data suggest Chinese economic growth bottomed in March and is rapidly recovering (Chart 6). Chart 6Chinese Economy Returning To Normal Meanwhile in China’s major export destinations, the number of confirmed COVID-19 cases appear to be flattening, containment measures are gradually easing, and mobility is improving (Chart 7, panel 1 and 2). Globally, the copper- and oil-to-gold ratios have stabilized, and stock prices for nine of the largest copper producers have trended up since March 23 (Chart 7, panel 3 and 4). That said, we believe it is still too early to adopt a high-conviction view about a price recovery trajectory. For one, China recently reintroduced containment measures in certain regions, as clusters of coronavirus cases were detected, highlighting the fragility of the current recovery.2 Chart 7China's Major Export Partners Could Rebound Soon Chart 8Strong Domestic Demand, Weak Export Growth Moreover, the rebound in overall Chinese demand hasn’t fully offset the collapse in its exports. As a result, the reopening of the supply side of the economy outpaced demand growth (Chart 8). Extrapolating this to its copper market: Chinese refined copper production (40% share of world output) is facing robust domestic demand but weak export demand for copper (44% and 9% of world demand), leaving its market with a supply surplus. Nonetheless, absent a severe second wave of COVID-19 cases, the infrastructure-focused stimulus and market-friendly real estate policies in the country will allow internal demand to overtake production in 2H20, despite limited external demand (more on this below). China’s Credit Growth To Drive Copper Demand Higher The key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy.  Markets were unimpressed by the fiscal package announced during China’s National People’s Congress (NPC) last month, which, for the first time in decades, did not contain an annual economic growth target in the Government Work Report (Table 1). Even so, the key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy. Broad money and total social financing growth will accelerate relative to last year and notably exceed nominal GDP growth. Our Emerging Markets strategists expect China’s fiscal and credit impulse will reach 15.5% this year (Chart 9).3 Table 1No Economic Growth Target In The Government Work Report Additionally, China pledged to stabilize employment and targeted the creation of 9 million new jobs in urban areas. This is an ambitious target amidst the massive layoffs induced by the COVID-19 pandemic this year. Chart 9Chinese Credit Growth Will Surge Policymakers also reserved policy space to be used – without the approval of the NPC at the Politburo’s mid-year review – in the event the shock from the pandemic proves persistent.4 Past episodes of Chinese stimulus resulted in strong rallies in base metals prices. Given China now represents more than half of global copper consumption (vs. 43% in 2009 following the GFC, and 32% in 2012 following the euro area debt crisis), we expect this new round of stimulus will lead to a sharp increase in copper prices.5 By and large, refined copper prices are highly sensitive to growth in EM imports – particularly China’s – which are closely tied to income growth. The latest CPB World Trade Monitor data for March shows EM ex-China imports have been resilient suggesting the rebound in China’s economic activity might be spilling over to other EMs highly leveraged to China (Chart 10). Still, our main cyclical commodity demand indicators were declining as of April. We expect stimulus-driven EM income and investment growth will show up in our indicators in 2H20 (Chart 10). Chart 10Awaiting A Rebound In Our Cyclical Indicators Stalling Primary And Secondary Supply Growth In addition to the demand implications, lockdowns also resulted in restrictions – and few complete shutdowns – in mining activities in copper-producing countries. The ICSG revised down its global mine and refined copper output by 950k MT and 1.1mm MT, respectively, for this year on the back of the COVID-19 pandemic.6 The group now expects 2020 mine supply to decline by 3% this year and refined production to remain flat y/y, for a second consecutive year. While important, these adjustments were insufficient to completely offset the large negative demand shock in 1Q and 2Q20.7 In 2H20, the supply-side outlook rests on the evolution of COVID-19 cases and associated governments’ responses in major ore and refined copper-producing countries (i.e. Chile, Peru, US, DRC, China, Russia, and Japan). So far, mining activities were mostly treated as essential and allowed to operate at reduced capacity under additional sanitary and social distancing guidelines. Confirmed cases in these countries appears to be slowing, this could allow activity to slowly return to normal (Chart 11). Chart 11Further Supply Disruptions Are Unlikely Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices.  While mining and refining of copper concentrates were often classified as essential, scrap activities were not. According to the ICSG, copper scrap supplied decreased significantly as trade flows and generation, collection, and disassembling activities were disrupted by the pandemic. China’s import of scrap copper – a key input for Chinese refiners – declined 37% in 1Q20. This prompted the government to allow more scrap imports to fill the gap, but it might struggle to find suppliers. Globally, scrap makes up ~ 25% of total refined copper supply, thus, it usually plays a non-negligible role in the rebalancing of global markets. Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices. In addition, the crisis began at an abnormally low inventory level. Thus, despite the temporary build in 1Q20, inventories are still below their 2010 to 2019 average. The rebound in demand, combined with flat supply and limited scrap availability, will move Chinese inventory down in 2H20 and offset any builds at the LMEX and COMEX warehouses, supporting copper prices this year (Chart 12). Chart 12Inventories Still Low Despite Builds In 1Q20 USD Depreciation Leads To EM Economic Growth Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD. As the COVID-19 shock abates we expect a weaker US dollar to be more supportive to copper demand. Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD (Chart 13). The shortage of USD experienced by EM debtors servicing dollar-denominated debt continues to hamper their recovery. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines is keeping the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin (Chart 14, panel 1). Chart 13Global Financial Cycles Hurting EM Economies Chart 14Uncertainty Keeps USD Well Bid The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. EM economies – the bulk of base metals demand growth – are facing dual domestic demand and global financial shocks.8 These economies have become more dependent on foreign portfolio inflows, both in debt and equity markets (Chart 14, panel 2). Thus, global financial cycles now have a significant impact on their growth. The main factors influencing these flows are risk appetite, EM exchange rates, and DM interest rates.9 We expect all factors to support inflows to emerging markets as the COVID-19 shock abates. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. A lower USD will decrease the local-currency cost of consuming commodities ex-US. Metals producers' ex-US will face higher local-currency operating costs, reducing supply growth at the margin. A depreciating USD is a necessary factor for our bullish cyclical commodities view (Chart 15). The risk to this view is a severe second wave of COVID-19 infection which would cause safe assets to spike anew. Chart 15Metals Inversely Correlated With The US Dollar $3.00/lb Copper Price Likely; Geopolitical Risks Mounting Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets.  For April, our copper demand model suggested prices were at equilibrium relative to underlying demand trends (Chart 16). Chart 16Copper Prices Will Rise As The USD Depreciates When simulating a 10% decline in the USD and a rebound in EM import growth in 2H20, our model suggests COMEX copper prices could move 25% higher, holding everything else constant. In reality, the USD’s path and the extent of the EM import rebound are among the key known unknowns we confront in estimating a model for copper prices. We do not have a precise view on these variables, which is why we run simulations. Theory would suggest the stimulus we are seeing globally points to a lower USD and a pick-up in EM imports, however, and these factors will create a more supportive environment for metals prices. Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets. With the US election now only 5 months away, President Trump’s odds of being reelected on the back of a strong economy are fading amidst the COVID-19 pandemic. According to our Geopolitical strategists, Trump is the underdog and will need to double down on foreign and trade policies to prop-up his chances of winning. Meanwhile, China is seeking to solidify its sphere of influence.10 This is causing US-China tensions to intensify. Depending on the nature of the actions taken by the Trump administration (i.e. increasing tariffs on US imports of Chinese goods vs. cutting China’s access to foreign technology), metals prices could suffer, as was the case in 2018. With these geopolitical risks in mind, we maintain that China’s strong fiscal and monetary stimulus, combined with a falling US dollar will provide a favorable backdrop for copper markets in 2H20.   Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Doubts about OPEC 2.0’s commitment to extending their deepest-ever production cuts expiring this month to July, perhaps August, took some of the steam out of crude-oil rally earlier in the week. In our modeling, we do not see the need to extend the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies: KSA’s cuts of ~ 4.5mm b/d vs. its April output level of 12mm b/d starting this month will take the Kingdom’s output to ~ 7.5mm b/d. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. We continue to believe the current schedule of production cuts will result in a physical supply deficit in 3Q20, which will require OPEC 2.0 to begin raising production to keep prices from getting too high going into a US presidential election. We expect Brent prices to average $40/bbl this year and $68/bbl next year, with WTI trading $2 - $4/bbl below that (Chart 17).11 Base Metals: Neutral Iron ore prices breached $100/MT this week, as COVID-19-induced supply disruptions in Brazil – the largest exporter of high-grade ore – and South Africa leave the seaborne market open to Australian suppliers to meet higher Chinese demand as port inventories are rebuilt. FastMarkets MB, a sister company of BCA Research, reported May exports to China from Brazil were down 28% y/y to 21.5mm MT from just under 30mm MT the year prior. Iron ore exports from Australia are expected to exceed A$100 billion this year, according to government estimates reported by the Financial Times.12 Precious Metals: Neutral As we go to press, gold prices retreated to $1,700/oz from ~ $1,740/oz last week, exhibiting a positive correlation with the dollar. This is a result of rising risk appetite globally as economies exit lockdowns. In the US, interest rates are continuing to support gold. Going forward, the probability of negative rates is remains low, but the Fed will continue to buy more debt from the public and private sectors to push the shadow rate further down. This supports gold prices (Chart 18). Chart 17Crude Prices Will Rebound Chart 18Fed Buying Supports Gold Prices     Footnotes 1     Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 2     A resurgence of infection triggered renewed lockdowns over a region of 100 million people in May. Please see More than 100 million people in China's northeast back under lockdown to thwart potential second wave published by the National Post on May 19, 2020. 3    Please see BCA's Emerging Markets Strategy Weekly Report "EM Stocks Are At A Critical Resistance Level," published May 28, 2020. It is available at ems.bcaresearch.com. 4    Please see BCA's China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," published May 28, 2020. It is available at cis.bcaresearch.com. 5    There remains a risk global monetary stimulus fails to ignite strong consumer and business consumption. The unprecedented shock could raise precautionary savings and keep risk aversion elevated for an extended period. Based on the Quantity Theory of Money, money supply times velocity (the rate at which money changes hands) equals nominal GDP. Low confidence translates to a low velocity of money limiting the reach of monetary policy. This value is extremely difficult to forecast. 6    Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 7     According to BGRIMM Lilan Consulting, China’s real demand for refined copper declined by ~22% in 1Q20. This implies a ~11% decline in global copper consumption. Please see footnote 6 for more details. 8    Global financial cycles capture how global financial conditions affect individual economies. The analysis of these cycles stressed the importance of common factors in global risk asset prices which are driven by risk appetite and US monetary policy. These factors are mainly explained by developments in advanced economies but have a drastic effect on emerging markets. Please see Iñaki Aldasoro, Stefan Avdjiev, Claudio Borio and Piti Disyatat (2020). “Global and domestic financial cycles: variations on a theme,” BIS Working Papers, No 864. 9    Please see Chapter 3 of the Global Financial Stability Report titled “Managing Volatile Portfolio Flows,” published by IMF. 10   Please see BCA's Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," published May 29, 2020. It is available at gps.bcaresearch.com. 11    Please see our May 21, 2020 report entitled US Politics Will Drive 2H20 Oil Prices for our latest view on oil fundamentals and prices, available at ces.bcaresearch.com. 12    Please see Australia’s iron ore miners exploit supply gap as Covid-19 hobbles rivals published by the Financial Times June 3, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights Risks assets have entered­ a FOMO-driven mania phase that could last for a few more weeks. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this mania phase runs out of steam.  We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. Within EM, local rates will perform well in both risk-on and risk-off phases. Feature The recovery in global risk assets has entered a fear-of-missing-out, or FOMO, mania phase. Like any mania, this one could last longer and go further than any fundamental analysis could presume. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy. Within EM, local rates offer the best risk-reward profile.  A recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. The global equity rally has taken place amid a shrinking forward EPS. The top panel of Chart I-1 demonstrates that even the ever-bullish bottom-up analysts have been cutting their expectations of the level of corporate 12-month forward earnings per-share. As a result, the global forward P/E ratio has spiked to a 18-year high (Chart I-1, bottom panel).   Chart I-1An Unprecedented Divergence: Surging Stocks Prices Amid Plunging Forward EPS Levels Chart I-2EM Forward EPS Level Has Been Falling Chart I-2 illustrates that the same phenomenon is true for EM equities. Their forward EPS has been contracting and their forward P/E has jumped to a decade high.  Any overdrive in asset prices without supporting fundamentals can last for a while but typically ends with a crash. This FOMO-driven mania is unlikely to be any different. It is fair to say that during the March carnage, many investors operated on a “sell now, think later” principle. Since the rally began, they have switched to a “buy now, ask questions later” attitude. As this rally persists, global stocks and credit will become overbought and expensive. At that point, any negative shock could produce a sharp pullback that would likely devolve into another nasty selloff as investors shift back to a “sell now, think later” mentality. The Narratives Driving The Rally The narratives supporting this mania are simple and seem to be both accepted and embraced by a growing number of investors. We agree with some and disagree with others: Economies around the world are opening, which will ensure that an economic recovery will follow. Our interpretation: Surely as confinement policies are eased, activity will improve. However, in our opinion, this should not come as a surprise to investors. This is especially pertinent for the trend-setting US stock market. With US equity valuations not particularly cheap, the market was never pricing in extended lockdowns. Hence, it appears strange to us that markets have so exuberantly cheered the reopening of the economy. Looking forward, the key to the medium-term (six-month) equity outlook is the shape of the recovery following the initial partial normalization. The latter presently looks V-shaped because as stores and businesses reopen economic activity is bound to improve. Yet the odds are that following this initial normalization, the shape of the recovery is most likely to be U-shaped. For what it’s worth, manufacturing PMIs in export-oriented economies like Korea, Japan and Taiwan made new lows in May (Chart I-3). We are not suggesting these indicators will not improve in the months ahead; they surely will. Nevertheless, a marginal rise in diffusion indexes like PMIs from extraordinary depressed levels do not signify a profit recovery. This recession differs from previous ones as the level of business activity has dropped below breakeven points for more businesses than it did in other recessions. When a company operates below its breakeven level, a marginal rise in sales may not be sufficient to improve its debt-servicing capacity, hiring and capital spending intentions. However, it seems markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. This is why we feel risk assets are in a FOMO-driven mania phase, where fundamentals do not matter. Authorities around the world are stimulating, with the US pumping enormous amounts of fiscal and credit stimulus into the economy (Chart I-4, top panel). Chart I-3Asian Manufacturing PMIs Made New Lows In May Chart I-4An Unparalleled Global Money Boom   Chart I-5China Is Ramping Up Stimulus China has finally embarked on aggressive stimulus. The National People’s Congress has set the monetary policy objective for 2020 as follows: Substantially accelerate the growth of broad money supply and total social financing (Chart I-4, bottom panel). Our interpretation: Indeed, government stimulus worldwide is massive. Yet, it is hard to know if it will be sufficient to produce a V-shaped recovery. The rise in money supply at the moment is being offset by the drop in the velocity of money. As a result, nominal GDP levels are extremely low. That said, last week we upgraded our growth outlook for China because of the above-mentioned aggressive policy stimulus. It is possible that China’s credit and fiscal impulse will reach about 15% of GDP before year-end (Chart I-5). What presently deters us from recommending outright long positions in China-related plays is the escalating US-China confrontation and the risk of a relapse in global stocks. Central banks around the world both in DM and EM are monetizing debt and injecting immense liquidity into the system. Our interpretation: Correct, but equally relevant is investors’ animal spirits. The latter will determine whether and when these liquidity injections leak into risk assets. For now, it seems that once again central banks’ actions have been successful in lifting asset prices, despite poor fundamentals. Equity valuations are cheap, especially outside the US. This is especially true given the low risk-free rate. Our interpretation: We agree that EM equities are cheap, something we have been highlighting since mid-March (Chart I-6). Yet valuations are not a good timing tool, as they can stay depressed so long as profits are not worsening.  Meanwhile, US equities are expensive (Chart I-7). Critically, we argued in a recent report that equity multiples depend not only on the risk-free rate but also on the equity risk premium (ERP). Chart I-6EM Equities Are Cheap Chart I-7US Stocks Are Expensive   Given the immense ambiguities investors are facing with respect to both the business cycle and economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. In this context, US equity valuations are rather expensive, despite the very low risk-free rate. In short, the expensive US stock market has until very recently been the locomotive of this rally. If US share prices had not rallied hard in the past two months, EM and other international bourses would not have caught a bid. The Fed’s public debt monetization is a structural, not near-term negative for the greenback. The US dollar is expensive and will depreciate a lot due to unrestrained fiscal and monetary stimulus in the US. Our interpretation: The US dollar is one standard deviation expensive (Chart I-8) and EM currencies have become cheap (Chart I-9). Chart I-8US Dollar Valuations Are Elevated Chart I-9EM Currencies Are Cheap   Chart I-10EM Currencies And Stocks Correlate With Industrial Metals We do not disagree with the view that the US dollar is vulnerable in the long term due to the Federal Reserve’s aggressive debt monetization and that the Fed will eventually fall behind the inflation curve. Yet inflation is not imminent, and the Fed’s public debt monetization is a structural, not near-term negative for the greenback. As such, these potholes for the US dollar may not be pertinent in the next several months. Critically, Chart I-10 illustrates that EM currencies move with industrial metals prices, and EM stocks correlate with global materials stocks. The common driver of all of these markets is global growth in general and China’s industrial sectors in particular. In short, a recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. Investors are underinvested in global equities in general and cyclical plays in particular. Our interpretation: Indeed, we showed last week that institutional equity investors had been skeptical of this rally. What has driven or supercharged this equity rally since late March has been unsophisticated retail investors. They have been opening up broker accounts worldwide and aggressively trading since March lockdowns. We cited a few pieces of anecdotal evidence confirming this phenomenon in last week’s report.  However, it seems that institutional investors in recent weeks have capitulated by raising their risk exposure in general and their exposure to cyclical plays in particular. This explains the recent surge in cyclical equities and currencies.  Bottom Line: The narratives driving this rally are only partially correct. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this FOMO-driven mania phase runs out of steam.  Nuances To Beware Of There are several nuances about the market’s internals and characteristics that we would like to draw investors’ attention to: There is mixed evidence as to whether China’s economy in general and its industrial sectors in particular have entered a sustainable recovery. First, examining the Taiwanese manufacturing PMI data could help in assessing the growth outlook for both the mainland economy and for global trade. The basis is that Taiwan has done extremely well by avoiding COVID-19 outbreaks and lockdowns. Therefore, there are no domestic reasons for weak output growth. In addition, its manufacturing sector is very export-oriented, with about 40% of exports destined for mainland China. PMI export orders for Taiwan's aggregate manufacturing and its three key sectors plunged to new lows in May (Chart I-11). This includes both the electronic optical (semiconductor) and basic materials sectors. The latter correlates well with global materials stocks. There has so far not been a bullish signal from this indicator (Chart I-11, second panel).    Second, China’s domestic A-share market in general and its cyclical sectors in particular have not yet broken out (Chart I-12). Given China was the first nation to exit from lockdowns, its share prices should be the first to signal a sustainable economic recovery. Yet onshore share prices have been rather subdued. China’s economy will eventually stage a recovery later this year. Our point is that global cyclicals might have run ahead of themselves by pricing in a recovery too early. Chart I-11Taiwanese Manufacturing PMIs In May: New Lows Across All Industries Chart I-12Chinese Onshore Share Prices Are Not Flagging An Imminent Recovery   Equity market and sector leadership changes occur during selloffs or at the inception of rallies.  Chart I-13 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM. And all of them occurred during selloffs in global share prices. Chart I-13EM Versus DM Equity Leadership Rotations Took Place During Selloffs Similarly, the relative performance of global growth versus value stocks experiences trend reversals during global bear markets (Chart I-14). Chart I-14Global Growth Versus Value Leadership Rotations Occurred During Bear Markets Chart I-15EM Could Outperform DM For A Few Weeks Leadership of US equities and global growth stocks did not change during the March crash nor during the following two-month rally from the bottom. Only in the past week or so have US equities and global growth stocks begun to lag EM bourses and global value, respectively (Chart I-15). In brief, the latest leadership rotation from US to EM did not occur during the selloff or at inception of the rally – i.e., it does not fit the typical profile of sustainable leadership reversal. As such, it may not be enduring. The internals of this rally are consistent with the fact that it might already be at a late stage. During rallies, laggards are the last to catch a bid. Contrarily, during selloffs, outperformers are the last to be liquidated. For example, US growth stocks were the last ones to be liquidated in both the 2015-early-2016 and 2018 selloffs. When the decade-long leaders – US growth stocks – were finally stamped out, it marked the bottom of those selloffs. We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Using an analogous framework for this rally, the latest extraordinary spike in the laggards such as EM, Europe and both value and cyclical stocks could be a sign of bear capitulation, and could signify the final phase of this equity rally.  Bottom Line: There are several nuances to the current equity market rally, but investors seem reluctant to consider them amid a FOMO-driven mania. Investment Considerations The FOMO-driven rally could last for several more weeks. Afterwards it will be followed by a major setback. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy.  Chart I-16EM Local Rates Offer Value We are making the following adjustments and changes to our strategy and trade recommendations: In regard to our EM versus DM asset allocation strategy, we are making one change: we are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Consistently, we are closing two positions: (1) our short EM corporate and sovereign credit / long US investment-grade corporate bond trade; and (2) our long Asian investment-grade /short high-yield corporate bond trade. Within the EM credit space, we continue to favor sovereigns versus corporates – a strategy recommended on April 23. We are still reluctant to strategically upgrade EM stocks versus DM ones even though odds of EM outperforming DM stocks are high in the coming weeks. In light of the potential FOMO-driven rally, to protect profits we are closing the following two currency positions: Take profits on short BRL/long USD trade. It was initiated on November 29, 2019 and has produced a 19% gain. Book profits on short SGD/long JPY position. This recommendation has generated a 2.3% gain since its initiation on June 8, 2018. We are still maintaining shorts in the following EM currencies: CLP, ZAR, TRY, IDR, PHP and KRW. They could continue rallying in the near term but will relapse afterwards. We are also structurally short low beta currencies: the RMB and the Saudi riyal. Within EM, local rates offer the best risk-reward profile: they will perform well in both risk-on and risk-off phases. Real bond yields remain somewhat elevated in many EMs, as shown in Chart I-16. We continue to receive long-term rates in Mexico, Colombia, Russia, Ukraine, India, Pakistan, Malaysia, China and Korea, as well as 2-year rates in South Africa. Their central banks will reduce policy rates much further. In addition, several of these local bond markets will benefit from ongoing quantitative easing by their central banks. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The Chinese economy continues to recover, albeit less quickly than the first two months following a re-opening of the economy. The demand side of the Chinese economic recovery in May marginally outpaced the supply side, with a notable improvement concentrated in the construction sector. We are initiating two new trades: long material sector stocks versus the broad indices, in both onshore and offshore equity markets. Feature The recovery in China’s economy and asset prices has entered a “tapering phase”, in which the speed of the recovery is normalizing from a rapid rebound two months after the economy re-opened. The direction of the ultra-accommodative monetary and fiscal stance has not changed, but the aggressiveness in the stimulus impulse is abating as the recovery continues. As we highlighted in last week’s report, the announced stimulus at this year's NPC was less than meets the eye of investors.1 Chart 1A Quick Reversal In The Outperformance Of Chinese Stocks Near-term downside risks in Chinese stocks were highlighted by last week’s quick reversal in the outperformance of Chinese equities relative to global benchmarks (Chart 1). As the US and European economies re-open and the stimulus impulse in major developed markets (DMs) is at peak intensity, Chinese stocks will underperform those in DMs, particularly US stocks. The re-escalation in Sino-US tensions will also add to the near-term volatility in Chinese equities. Therefore, we maintain our tactical (0-3 months) neutral view on aggregate Chinese equity indexes, in both domestic and offshore markets. Beyond Q2, however, our baseline view still supports an outperformance in Chinese stocks. The stepped-up stimulus measures since March should start to trickle down into the broader economy. Global business activities and demand will slowly normalize in the summer, helping to revive China’s exports. Moreover, an intensified pressure on employment, indicated in this month’s employment subcomponents in manufacturing and non-manufacturing PMIs, should prompt policymakers to roll out more growth-supporting measures in Q3. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Chart 2ASpeed Of Manufacturing Activity Recovery Has Moderated China’s official manufacturing PMI slipped to 50.6 in May from 50.8 a month earlier (Chart 2A). While the reading suggests that manufacturing activities are still in an expansionary mode, the speed of the expansion has moderated compared with April and March. The supply side of manufacturing activities and employment were the biggest drags on May’s official PMI. The production subcomponent in the PMI decelerated whereas new orders increased from April (Chart 2A, bottom panel). The net result is an improved supply-demand balance in the manufacturing sector, however, the improvement is marginal. It also differs from the V-shaped recovery in 2008/09, when both new orders and production subcomponents grew simultaneously (Chart 2B). The demand side of the economy is still concentrated in the policy-driven construction sector. The rebound in construction PMI continues to significantly outpace that in manufacturing and non-manufacturing PMIs (Chart 2C, top panel). The construction employment sub-index ticked up by 1.7 percentage points in May, compared with a slowdown of 0.8 percentage points in manufacturing and 0.1 percentage points in non-manufacturing employment PMIs (Chart 2C, bottom panel). Chart 2BDemand Struggles To Outpace Supply Chart 2CDemand Recovery Is Concentrated In Construction While a buoyant construction sector should provide a strong tailwind to raw material prices and related machinery sales, a laggard recovery from other sectors means the upside potential in aggregate producer prices (PPI) will be limited in the current quarter. In May, there was a rebound in the PMI sub-indices measuring raw material purchase prices and ex-factory prices, which heralds easing in the contraction of PPI in Q2 (Chart 3). However, neither of the PMI price sub-indices has returned to levels reached in January, when PPI growth was last positive. Moreover, weaker readings in the purchases and raw material inventory subcomponents suggest that manufacturers may be reluctant to restock due to sluggish global trade and a lagging rebound in domestic demand (Chart 3, bottom panel).  This month’s PMI shows that the employment subcomponents in both the manufacturing and non-manufacturing PMIs are contracting (Chart 4). Because demand for Chinese export goods remains sluggish, we expect unemployment in China’s labor-intensive export manufacturing sector to rise in Q2 and even into Q3. The intensified pressure on employment will likely prompt Chinese policymakers to roll out more demand-supporting measures. Chart 3PPI Contraction Will Ease But Upside Limited In Q2/Q3 Chart 4Employment In Trouble, A Catalyst For More Easing The BCA Li Keqiang Leading Indicator rose moderately in April. A plunge in the Monetary Conditions Index (MCI) limited the magnitude of the indicator's increase, offsetting an uptick in money supply and credit growth (Chart 5). A rapid disinflation in headline consumer prices (CPI) since the beginning of this year has pushed up the real savings deposit rate, which contributed to the MCI’s nose-dive. In our view, the MCI’s sharp drop is idiosyncratic and does not signify a tightening in the PBoC’s monetary stance or overall monetary conditions. Huge fluctuations in food prices have been driving the headline CPI since March 2019, while the core CPI remains stable. While food prices historically have very little correlation with the PBoC's monetary policy actions, a disinflationary environment will provide the central bank more room for easing. Odds are high that the PBoC will cut the savings deposit rate for the first time since 2015.  Chart 5Monetary Conditions Are Not As Tight As The Indicator Suggests The yield curve in Chinese government bonds quickly flattened around the time of the National People’s Congress (NPC), with the short end of the curve rising faster than the long end (Chart 6). This is in keeping with our assessment that while the market is expecting the recovery to continue in China, it is unimpressed with the intensity of upcoming stimulus and monetary easing. Monetary easing seems to be taking a pause, but we do not think this indicates a change in the PBoC’s policy stance (Chart 7). Instead, weak global demand, slow recovery in the domestic economy and intensified pressure on domestic employment, all will incentivize policymakers to up their game by mid-year. As such, we expect the yield curve to steepen again in H2, with the short-end of the curve fluctuating at a low level and the 10-year government bond yield picking up when the economy gains traction. Chart 6The Bond Market May Be Incorrectly Pricing In A Monetary Tightening Chart 7A Pause Before More Easing In June The spread in Chinese corporate bond yields has dropped by more than 30bps from its peak in April. This is in line with that of major DM countries and a reflection of the easier liquidity conditions globally (Chart 8). We anticipate that the yield spreads in Chinese corporate bonds will continue to normalize. However, a flare in US-China tensions will put upward pressure on the financing costs of lower-rated corporations (Chart 8, bottom panel). The default rate among Chinese corporate bonds is unlikely to rise meaningfully this year, in light of ultra-accommodative monetary conditions and the Chinese government’s bailout programs to backstop corporate defaults. Chinese corporate bond defaults and non-performing loans historically have correlated with periods of financial sector de-leveraging and de-risking, other than during economic downturns. We continue to recommend investors hold China’s corporate bonds in the coming 6-12 months in a USD-CNH hedged term. Chart 8Financing Costs May Rise For Lower-Rated Corporations Chart 9Cyclicals Are Struggling To Break Out Among Chinese equities, cyclical sectors have struggled to outperform defensives in both onshore and offshore markets (Chart 9). This reflects investors’ concerns over the slow recovery in domestic demand and heightened geopolitical risk between the US and China. As such, we continue to favor domestic, demand-driven sectors among the cyclical stocks, such as consumer discretionary and construction-related materials. We upgraded consumer discretionary stocks from neutral to overweight on May 20, and we are now initiating two trades to long material sector stocks versus the broad markets in both the domestic and investable markets. The constituents of both China’s investable and domestic material sectors are highly concentrated in the metal and mining subsectors, which roughly account for half of the material sectors’ weight in the MSCI and MSCI A Onshore Indexes, respectively. Chart 10 highlights that the material sectors’ relative performance is highly correlated with CRB raw materials in both domestic and investable markets. Given that China’s credit cycles historically lead the CRB material index by about six months, China’s massive credit stimulus will boost CRB raw materials by end-Q2 and thus, the outperformance of the material sectors.  The RMB has depreciated by almost 3% in the wake of a re-escalation in US-China frictions. The CNY/USD spot rate is approaching its weakest point reached in September 2019 (Chart 11). Furthermore, on May 29, the PBoC set the CNY/USD reference rate at its lowest level since 2008, a move that suggests defending the RMB is no longer in China’s interest. Downward pressure on the RMB will persist in the months leading up to the November US presidential election. The US economy is in a much more fragile state than in 2018/19, which may hinder President Trump’s willingness to resort to tariffs between now and November. However, we cannot completely roll out the probability that Trump will impose further tariffs on Chinese exports, if he is losing the election through weak public support and is removed from his financial and economic constraints.  In any case, in the coming months CNY/USD exchange rate will likely continue to decouple from the economic fundamentals such as interest rate differentials (Chart 11, bottom panel). Instead, the exchange rate will be largely driven by market sentiment surrounding the US-China frictions.  Volatility in CNY/USD will increase, but the overall trend in the CNY/USD will continue downwards as long as the escalation in US-China tensions persists. On a 6- to 12-month horizon, however, we expect that the depreciation trend in the RMB to moderately reverse as the Chinese economy continues to strengthen. Chart 10Material Sectors Should Benefit From The Stimulus And Construction Boom Chart 11The CNY/USD Will Continue To Decouple From Interest Rate Differentials Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," dated May 28, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Feature The key to how markets will move over the coming 12 months is whether the coronavirus pandemic turns out to be a short-term (albeit severe) disruption to the world economy, or something more fundamentally damaging. Markets currently – with global equities up by 34% since March 23 – are clearly pricing in the former. They seem to be saying that the sudden stop to the economy – with US employment, for example, rising to a post-war high in just two months (Chart 1) – is not a problem, since most of the unemployed are furloughed and will quickly return to work once businesses reopen. Enormous stimulus (direct fiscal spending in G20 countries of 4.6% of GDP, even if loans and guarantees are excluded – Chart 2) and aggressive monetary policy (major central banks’ balance sheets have ballooned by $4.7trn since March – Chart 3) will tide us over until normality returns, and then provide a big boost to risk assets. Unprecedented efforts by drugs companies will soon produce a vaccine against COVID-19. Recommended Allocation   Chart 1Can Unemployment Come Down As Quickly? Chart 2Unprecedented Fiscal… Chart 3...And Monetary Stimulus All this is possible. Certainly, the amount of excess liquidity being pumped into the economy by central banks (Chart 4) could dramatically boost economic activity and asset prices once the world returns to normal. The newsflow over coming months may largely be positive, with a gradual easing of lockdowns, a rebound in economic data (it cannot mathematically get any worse), and an abatement of the pandemic during the northern hemisphere summer. Many investors remain pessimistic (Chart 5) and so may be pulled into markets if stocks continue to rise. In this environment – and with the alternatives so unattractive (10-year US Treasurys at 0.6% anyone?) – we wouldn’t want to take a bet against equities. Chart 4Liquidity Will Boost Assets - Eventually But is the market ignoring the risks? Easing of lockdown could lead to a flare-up of new COVID-19 cases: China has already had to reintroduce some containment measures when this happened (Chart 6). Chart 5Retail Investors Remain Bearish   Chart 6What Happens When Lockdowns Are Eased? While COVID-19 cases have peaked in Asia, Europe, and North America, there is a new wave in Emerging Markets, particularly those such as Brazil which were lax in implementing containment measures (Chart 7). Even where the pandemic has waned, consumers seem highly reluctant to go to restaurants (Chart 8) or fly on airplanes (Chart 9). Chart 7The Pandemic Is Shifting To Emerging Economies Consumer-facing companies may no longer see revenues down by 70% or 80% over the next few months, but they could still be 10% or 20% below normal levels. How many business models are robust enough to survive that? As for a vaccine, it is worth remembering that no vaccine has ever been developed for a coronavirus in humans. We may have to learn to live with the disease. Chart 8Consumers Are Not Yet Going To Restaurants... Chart 9…Or On Planes The longer the pandemic lasts, the more damaging will be its second-round effects. Already banks are turning more cautious about lending (Chart 10), and rating agencies are rapidly downgrading companies (Chart 11). We are likely to see a wave of corporate defaults, Emerging Market borrowers struggling to service their foreign-currency debts, and banks getting into trouble as a result – though monetary and fiscal bridging programs may defer these problems for a while. Chart 10Banks Are Turning More Cautious... Chart 11...And Companies Are Being Downgraded The US/China relationship is also a concern in the run-up to November’s US presidential election. It will be tempting for President Trump to turn tough on China, a policy that could be popular with the US electorate, which has become more anti-China in recent months (Chart 12). Problems over Hong Kong, China failing to hit the import targets it promised in January’s trade agreement, and action against Huawei (whose license expires in mid-August) mean that the conflict could escalate quickly. China would also much prefer Joe Biden as US president, and will do nothing to help President Trump get reelected. Chart 12Being Tough On China Is Popular In The US Chart 13The Dollar Has Not Reacted To The Risk-On Rally In this environment of unusual uncertainty, we continue to leaven our benchmark-weight position in global equities with relatively cautious tilts: overweight the lower-beta US market and structural-growth sectors such as Healthcare and Tech. We maintain our large position in cash, and would continue to hold gold as a hedge against tail risks. The risk to this view is that over coming months – if the environment continues to stabilize – there is a vicious rotation into pure cyclical plays, perhaps driven by a fall in the US dollar (which has until recently been surprisingly stable during the past two months’ risk-on rally – Chart 13), a rise in commodity prices, and higher long-term interest rates. This scenario would trigger outperformance by Emerging Markets and eurozone stocks, and value-oriented sectors such as Materials and Financials. This might be possible for a short period but, given the risks highlighted above, we would not recommend long-term investors to shift their portfolios in this direction.   Equities: Our “minimum volatility” approach has worked well: US equities and structural growth sectors such as Healthcare and Tech continued to outperform both during the sell-off in February and March and in the subsequent rebound (Chart 14). For now, we prefer to stick to this cautious stance on a 12-month investment horizon. It is possible, though, that there could be some short-term rotation into value and small cap stocks if the environment improves further over the next couple of months (Chart 15). We are partially hedged against this sort of upside surprise through our overweight in Industrials (which would benefit from a ramp-up in Chinese infrastructure spending, in particular) and neutral on Emerging Markets and Australia. Chart 14"Min Vol" Equities Have Outperformed Chart 15Could There Be A Shift To Value And Small Caps? Fixed Income: Government bond yields have not risen despite the risk-on rally, and we expect this to remain the case. Continuing uncertainty, central bank insistence that easy monetary policies will stay in place for a long time, and deflationary pressures over coming months warrant a neutral stance on duration – though returns from high-quality government bonds will be around zero. In the longer-run, however, the pandemic is likely to prove inflationary: like in a post-war environment, excess liquidity, supply constraints, and pent-up demand could push up consumer prices in 12 months’ time. Consumers are already noticing that the goods they are actually buying now (as opposed to the weightings in the consumption basket used to measure inflation) are rising in price (Chart 16). We recommend TIPS as a hedge, particularly given how cheap they are (with the 10-year breakeven at only 1.2%). Corporate credits that are supported by central bank buying remain attractive, although with spreads having already contracted the easy money has been made (Chart 17). BCA Research’s fixed-income strategists prefer US and UK investment-grade and BB-rated corporate bonds in the Media, Financials and Energy sectors.1 Chart 16Consumers Are Sniffing Out Inflation Chart 17The Easy Money Has Been Made In Credit Currencies: It will pay to watch the US dollar. It is overvalued and no longer supported by interest rate differentials, but as a safe haven currency has seen inflows given global economic uncertainty. For now, we remain neutral. Emerging Market currencies are likely to remain under pressure, particularly since EM central banks have followed the example of their Developed Market counterparts and for the first time embarked on QE to boost their economies (Chart 18). This could lead to rising inflation in some EMs, as central banks essentially monetize government debt. Chart 18EM Central Banks Are Starting QE Too Commodities: China has quietly been ramping up its credit growth, and this will eventually have a positive impact on industrial metals prices, which have showed tentative signs of bottoming (Chart 19). The rebound in oil prices has further to run. OPEC oil production is likely to fall by around 4 million barrels/day from its Q4 2019 level, with further output drops from capital-constrained North American shale producers (Chart 20).   Chart 19Industrial Commodities Bottoming? Harder to predict is how quickly demand – currently down around 15% year-on-year – will recover. BCA Research’s oil strategists, based on an assumption of a strong demand revival in H2, forecast Brent crude to rise above $50 a barrel by end-2020. Chart 20Oil Supply Has Fallen Significantly Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. Recommended Asset Allocation

Highlights China is taking advantage of global chaos to solidify its sphere of influence – beginning with Hong Kong. The crisis is also motivating the European Union to link arms more tightly through a symbolic step toward fiscal solidarity and transfers. US, Chinese, and European stimulus measures are cyclically positive but near-term risks abound. Hiccups in stimulus rollout are to be expected – and China’s disappointing stimulus thus far may cause market turmoil before policymakers do what we expect and add greater oomph. US-China relations are breaking down as we outlined, as renminbi depreciation coincides with Trump approval depreciation. The risks of the UK failing to agree to a trade deal with the EU are higher than prior to COVID-19. Stay defensive tactically – the risk-on rally is not yet confirmed by major reflation indicators yet geopolitical risks are spiking. Feature Chart 1Will Geopolitics Stunt The Early Bull's Growth? After wavering at the 2,900 level, the S&P 500 broke above 3,000. As we go to press, it is holding the line, despite a surge in geopolitical risk emanating from the efforts of the Great Powers to consolidate their spheres of influence at the expense of globalization. Key cyclical indicators are on the verge of breaking out. Our “China Play Index,” which consists of the Australian dollar, Swedish equities, Brazilian equities, and iron ore prices, is reviving smartly. The copper-to-gold ratio, however, is not really confirming the rally (Chart 1). Nor are Asian currencies. We recommend a tactically defensive stance. We are not dogmatic, but are not convinced that the rally will overcome near-term risks. We expect explosive political and geopolitical events throughout the summer. Near-Term Geopolitical Risks To The Rally Our reasons for near-term caution are as follows: Global stimulus hiccups: China’s National People’s Congress over the weekend disappointed expectations on the size of economic stimulus. This is a short-term risk, we argue below, but nevertheless a risk. The US Congress may not pass stimulus until July 2 and the final law will fall short of the House bill of $3 trillion. The European “Next Generation EU” recovery fund is only 750 billion euros in size and may not be agreed until July, or even September if the financial market does not impose urgency. We elaborate below. Ultimately policymakers will keep doing “whatever it takes” but there will be hiccups first and they will trouble the market in the near term (Chart 2). Chart 2Stimulus Tsunami Will Peak This Summer Sino-American conflict: The “phase one” trade deal was never going to bring durable comfort to markets about US-China cooperation, and the outbreak of COVID-19 prompted our March 13 argument that US-China tensions would erupt sooner than we thought. So far the market is grinding higher despite the materialization of this risk. Mega-stimulus and the equity rally enable the US and China to clash. At some point escalation will upset the market. Domestic stimulus is substituting for a collapse in globalization and risk markets are cheering. But increased domestic support will enable political leaders to clash with each other and keep upping the ante. The higher the market goes the more willing President Trump will be to expend some ammunition on China and other political targets. But if you play with sticks, somebody always gets hurt. The market is betting that Trump is a typical US president, typically bashing China in an election year. We are arguing that he is atypical, that this is an atypical election year, and that China’s own ambition cannot be left out of the equation. Wild cards: Jokers, one-eyed jacks, suicidal kings, and aces are all wild in this deck. Emerging markets like Russia (Chart 3) – and rogue regimes like Iran – pose non-negligible risks of upsetting the global rebound this year. Chart 3ARussian Risk To Rise Further On Libya, US Tensions Chart 3BRussian Risk To Rise Further On Libya, US Tensions   Chart 4Equity Investors Wise To Erdogan's Mischief Investors cannot focus on tail risks all the time, but not all geopolitical risks are tail risks. This is particularly the case because of the US election, which heightens Washington’s willingness to retaliate to any provocations. Geopolitics in the Mediterranean are verifiably unstable, particularly in Libya where Russia looks to make a major intervention yet Turkey is also involved (Chart 4). This affects North African and European security. Iran is under historic stress and will attempt to undermine the Trump administration as it has no downside to Democratic victory in November. In a recent event we hosted with the CFA Institute in India and Asia Pacific, only 4% of participants highlighted Russia and 2% Iran as a significant source of political risk this year, while 93% highlighted the US and China. Clearly the US-China competition is the great game. But other risks are underrated, especially Russia. Stimulus hiccups this summer are likely to be overcome in the US, EU, and China, so perhaps the market will look through this risk while economies reopen and leading indicators inevitably improve. US-China tensions could remain bound within Trump’s desire to keep the stock market up during his election campaign and China’s desire not to incur Trump’s unmitigated wrath if he happens to be reelected. Russian, Iranian, and emerging market risks, if they materialize, may have merely localized and ephemeral market effects. However, Trump’s falling approval rating and executive decree to open the social media companies to litigation supports our thesis that he is not enslaved by the stock market. The market is expecting “the Art of the Deal” to lead to positive outcomes but that assumption is not as reliable in a recessionary context as it is in an economic boom. The Atlanta Fed’s second quarter real GDP growth estimate stands at -40.4%. Any state that provokes the US over the next five months risks a massive or unpredictable retaliation. China will ultimately bring stimulus to 15.5% of GDP. Deflation and unemployment are a massive constraint. We do not mention the well-known risks of weak consumer activity and business investment amid the pandemic, which itself is expected to revive in the fall with no guarantee of a vaccine by then. Bottom Line: In the near term, maintain safe haven trades such as long Japanese yen, US Treasuries, and defensive equity sectors. China Stimulus Hiccups Won’t Last, But Will Sow Doubt The most important question in China is the implication of the National People’s Congress with regard to the size of stimulus. After the stimulus blowout of 2015-16, Xi Jinping consolidated power and launched a deleveraging campaign. His administration is determined to keep a lid on systemic risks, especially the money and credit bubble. Chart 5China's Stimulus Faces Doubts But Will Prove Huge In The End Beijing’s targets for central and local government spending disappointed market observers. In Chart 2 above, we revised Beijing’s fiscal stimulus from 11% of GDP to 4.3% of GDP as a result of lower-than-expected targets for local government special bonds and central government special treasury bonds, as well as a corrected calculation of the fiscal relief for small and-medium-sized enterprises. This 4.3% understates the real size of China’s stimulus because it includes only fiscal elements. Since the Communist Party and state bureaucracy control the banks and many large enterprises, one must also include credit growth – it is a quasi-fiscal factor. Total social financing (total private credit) is usually the biggest element of China’s periodic bouts of stimulus. While Chinese authorities showed restraint in their fiscal measures, they announced that credit growth would “significantly” exceed nominal GDP growth, which has collapsed due to the virus lockdowns. Our Emerging Markets Strategy estimates that credit growth will accelerate to 14% this year, making for an 11.2% of GDP increase in total credit, and a combined fiscal and credit impulse that will reach 15.5% of GDP (Chart 5). The dramatic global economic shock and the hit to China’s labor market ensure that additional stimulus will be applied as needed to plug the output gap. Soaring unemployment is a fundamental risk to social stability and hence to single-party rule. This means that the fiscal impulse will in the end likely exceed 4.3% as new measures are rolled out later this year. It also means that credit growth will surprise to the upside, as the regime loosens the reins on shadow banks as well as state-controlled lenders. Nevertheless, accepting our Emerging Market Strategy’s base case of 15.5% of GDP fiscal and credit impulse, we would note that China’s economy is much larger as a share of the global economy today than it was in previous rounds of stimulus. Thus while the stimulus may be smaller than that in 2008 as a proportion of China’s economy, it is larger as a proportion of the world’s (Table 1). China-linked asset prices, such as industrial metals, will see rising demand over time. Table 1China Fiscal+Credit Impulse Will Be Big Relative To World The Xi administration’s preference is not to overstimulate and exacerbate its problems of imbalanced growth, falling productivity, and excessive indebtedness. But its constraint is deflation, unemployment, and social instability. Insufficiently loose policy in the midst of a very deep global recession could prove to be the biggest policy mistake of all time. To refuse to loosen as needed, or to re-tighten policy too soon, would be to make a cruel joke out of the new policy slogan, “the Six Stabilities and Six Guarantees” and jeopardize Xi Jinping’s ability to reconsolidate power ahead of the twentieth National Party Congress in 2022. Rather the constraint will force policymakers to alter any hawkish preferences if growth looks to relapse. Bottom Line: Doubts about the sufficiency of China’s fiscal and monetary stimulus pose a near-term risk to global risk assets since investors face disappointing stimulus promises on the surface, combined with lack of certainty about Beijing’s willingness to increase stimulus going forward. We are confident that Beijing will ultimately do whatever it takes to stabilize employment and try to ensure social stability. But this implies near-term challenges and possibly a market riot prior to resolution. Before then, many market participants, including in China, will believe that the Xi Jinping administration will be hawkish and resistant to re-leveraging. China’s Sphere Of Influence Global geopolitical risk stems from the Xi Jinping regime at least as much as from the Donald Trump regime, as we have long pointed out. The scenario unfolding as we go to press is precisely the one we outlined back in March in which Beijing depreciates its currency to ease its economic woes while President Trump’s approval rating falls due to his own woes, prompting him to retaliate. The CNY-USD exchange rate is largely pricing out the phase one trade deal, which is marked by the peak in renminbi strength in Chart 6. Chart 6Phase One Trade Deal Priced Out Of Renminbi Already Chart 7China's Warning To Trump Could Scrap Trade Deal This depreciation is not merely the effect of market moves – though weakness in global and Asian trade and manufacturing certainly reinforce it. The People’s Bank of China’s fixing rate has been guiding the currency to its lowest point since 2008 amid the spike in US-China tensions over the past month (Chart 7). China says it will adhere to the phase one deal as long as it is mutual. It is buying more soybeans, cotton, pork, and beef from the United States relative to last year. Demand has collapsed. Unless China decides to dictate purchases as a subsidy to keep the agreement alive, its purchases will fall short of the huge expansion envisioned in the deal. US actions could nullify the deal anyway. President Trump and his Economic Director Larry Kudlow have both suggested that the administration no longer cares about maintaining the deal. China was fast becoming unpopular in the US and this trend has skyrocketed as a result of COVID-19. China’s other notable decision at the National People’s Congress was to state that it would impose a new national security law on Hong Kong SAR, after the autonomous financial center’s long reluctance to do so. Beijing has sought greater direct control of the city since early in Xi’s term, in contravention of the promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984. Beijing’s action comes after Hong Kong’s widespread civil unrest last year and ahead of the city’s Legislative Council elections in September, which will likely become a major geopolitical flashpoint. The United States is retaliating by removing Hong Kong’s designation as an autonomous region. This entails higher tariffs, tougher export controls, stricter visa requirements, and likely sanctions directed at mainland entities that will enforce the national security law in various ways, including eventually some Chinese banks. The US also accelerated sanctions against China for its civil rights abuses in Xinjiang – sanctions that target tech and security companies – and is moving forward with a bill to threaten Chinese companies that hold American Depository Receipts (ADRs) with delisting from American stock exchanges if they do not meet the same auditing requirements as other foreign companies. This potentially affects $1.8 trillion in market capitalization over a 3-4 year period. China’s power grab in Hong Kong initiates a market-negative Sino-American dynamic that will last all year. It cannot be assumed that Trump will accept Beijing’s implicit offer of swapping phase one trade deal implementation for China’s historic encroachment on Hong Kong’s autonomy. The imposition of legislative dependency on Hong Kong should not have been a surprise to investors given recent trends, but it was, as Hong Kong equities fell by 6% at first blush. There is more downside, judging by our China GeoRisk Indicator, which is in a clear uptrend for all of these reasons and correlates reasonably well with the Hang Seng index (Chart 8). Chart 8Hong Kong Equities Face More Downside From Geopolitics While the US will retaliate over Hong Kong, the question for global investors is whether the conflict spills over into the rest of China’s periphery. This would highlight the systemic nature of the geopolitical risk and make it harder for the market to swallow the new cold war. Our Taiwan Strait GeoRisk Indicator (Chart 9) is pricing zero political risk despite the clear risk that Beijing will eventually resort to economic sanctions to penalize the mainland-skeptic government there; that the US will seek to shore up the diplomatic and defense relationship in significant ways in what may be the final five months of the Trump administration; and that Taiwan may seek to draw the US into granting greater economic and security assurances. Chart 9Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Our Korea GeoRisk Indicator (Chart 10) has also fallen drastically. This risk indicator deviates from Korean equities frequently due to North Korean risks, which equity investors tend (usually correctly) to ignore. This year is different, however, because Kim Jong Un’s decision whether to give Trump a diplomatic win, or frustrate him with the test of a nuclear device or intercontinental ballistic missile, actually has a bearing on Trump’s election odds and the pace of US-China escalation. If Kim humiliates Trump then we expect Trump to make a major show of force in the region that would draw China into a strategic standoff. Chart 10North Korea Is Relevant In 2020 Due To Trump China is attempting to solidify its sphere of influence, first in Hong Kong but later in Taiwan and the Korean peninsula. The United States is pushing back and the US election cycle combined with massive stimulus means that push will come to shove. Bottom Line: Investors should steer clear of Chinese, Taiwanese, and Korean currencies and risk assets in the near term. We recommend playing the cyclical China recovery via Korean equities over the long run. The European Sphere Of Influence The European Union is also attempting to strengthen and expand its sphere of influence – namely with steps in the direction of a fiscal union. Our GeoRisk Indicators are generally flagging a huge drop in political risk for Germany, France, Italy, and Spain (Charts 11A & 11B). The reason is that the economies have collapsed yet the equity market has bounded back on ECB quantitative easing and huge promises of fiscal support. In the coming months these risk indicators will rise even as economies reopen because the debate over fiscal and monetary policies is heating up. Our base case is that both the debate over EU recovery funds and the German constitutional court’s objections to QE will resolve in dovish compromises. Chart 11AEurope’s Not-Quite Hamiltonian Moment Chart 11BEurope’s Not-Quite Hamiltonian Moment At issue on the fiscal front is the EU Commission’s “Next Generation EU” recovery fund. Commission President Ursula von der Leyen is offering to create a 750 billion euro relief fund (500 billion in grants, 250 billion in loans). The decision is contentious because it would entail the EU Commission issuing bonds – essentially joint bonds among the EU states – to raise funds that would then be distributed through the EU Commission seven-year budget (2021-7). Joint issuance would be a symbolic step toward greater solidarity. This proposal began with an agreement between French President Emmanuel Macron and German Chancellor Angela Merkel to launch the 500 billion in grants. Merkel signaled earlier this year that she was prepared to accept joint bond issuance focused on the immediate crisis. When more fiscally hawkish or euroskeptic states objected that loans should be used instead of grants, von der Leyen simply added their proposal to the total, despite the fact that the ECB and European Stability Mechanism (ESM) already offer emergency loans to help states through the global crisis. The proposal marks a victory of the fiscally dovish Mediterranean states (once called “Club Med”) over the frugal Germans, with Macron prevailing on Merkel to foist yet another major compromise onto her conservative German power base in the name of European integration and solidarity before she exits the chancellorship in 2021. But it is not as if German elites like Merkel and von der Leyen are running amok: German public opinion is Europhile and supportive of bolder actions to share burdens, save the union, and shore up the continental economy. The market is not pricing any political risk in Taiwan despite clear dangers. Stay short Taiwanese equities. The recovery fund itself is limited in size, relative to overall stimulus actions thus far. But it would plug an important gap for states like Italy and Spain, which are constrained by large public debt loads and have not provided enough stimulus as yet. The “Frugal Four,” the Netherlands, Austria, Sweden, and Denmark, are leading the opposition to the use of grants rather than loans and any effort to establish a track leading to European fiscal union. But they are also willing to negotiate. Estonia and other nations are also objecting, with the eastern Europeans seeking to ensure that southern Europe does not take the lion’s share of the funds, while the core European states will use the funds to pressure populist and euroskeptic eastern states that have defied the European Court of Justice and other institutions (Chart 12). Chart 12Europe: Distribution Of ‘NextGen EU’ Fund A final decision may not be settled by the time of a special summit in July but some compromise should be expected by the fall or (latest) end of year. The proposal would do the very thing that its opponents resist: pave the way toward jointly issued bonds in future that do not have a time limit or a single purpose (today’s sole purpose being pandemic relief). Hence the negotiations will be intense and it will likely require a return of financial instability to bring them to a conclusion. The global financial crisis and its aftermath provoked a higher degree of integration among the EU member states despite the tendency of the mainstream media to assume that the dissonance between monetary and fiscal policy would create an unbridgeable rupture. COVID-19 is now supporting this pattern of Brussels not letting a good crisis go to waste. Chart 13Europe Fends Off Latest Doubts About Solidarity The reason is that the EU is a geopolitical project. As Russia revived, the US began to act unilaterally and unpredictably, and China emerged as a global heavyweight, European powers were forced to huddle together ever more tightly to create economies of scale and improve their security against various external and unconventional threats. Influential German Finance Minister Olaf Scholz has compared the new recovery fund to the work of American founding father Alexander Hamilton in mutualizing the early American states’ war debt so as to create a tighter fiscal union among the states. For that very reason the more Euroskeptic member states oppose the proposal – long rejecting the idea of a “United States of Europe.” Today’s proposals are more symbolic, less substantial, than Hamilton’s famous Compromise of 1790. Nevertheless we would not underrate them as they highlight the way the European states continually turn crisis moments that worry the markets about European break-up into new opportunities to combine more closely. As such it is fitting that the European break-up risk premium has fallen, signifying a drop in peripheral bond spreads (Chart 13). The battle over debt mutualization is not over yet so spreads could widen again, but the trend will be down as the bloc develops new tools to combat the latest crisis. The United Kingdom obviously marks a major exception to this reinforcement of the European sphere of influence. The Brits are historically and geopolitically opposed to a unified continental political power. Having decided to leave, they lack the ability to obstruct from within. But they are also not necessarily more likely to yield in their trade negotiations. British political risks are understandably low because Prime Minister Boris Johnson and his Conservative Party won a strong mandate in December and technically do not have to face voters again until 2024. The major limitation on a “no trade deal” outcome in talks with Brussels was a recession – yet that has already occurred. London could ultimately bite the bullet and accept that outcome if the trade talks turn acrimonious. The GBP/EUR is not pricing a full “no deal” exit. Stimulus and economic recovery suggest that it is a good time to go long sterling but we will pass on this trade in the short run due to resilient dollar strength and the reduced barrier to exiting without a trade deal (Charts 14A & 14B). Chart 14ABrexit Trade Talks Not Globally Relevant Chart 14BBrexit Trade Talks Not Globally Relevant Bottom Line: We do not yet recommend reinstituting our long EUR/USD trade, which we initiated late last year as part of our annual forecast. The COVID-19 crisis has created such a spike in geopolitical and political risk that we expect the US dollar to remain surprisingly strong throughout the coming months and for US equities to outperform global equities beyond expectation. Nevertheless we will look to reinitiate this long-term trade at an appropriate time, as it fits squarely with our “European Integration” theme since 2012. Investment Takeaways Our contention that “geopolitics is the next shoe to drop” has materialized. This has negative near-term implications for global risk assets. However, thus far, market positives have outweighed negatives for global investors faced with the reopening of economies and wartime-magnitude fiscal and monetary stimulus. Buying risky assets makes sense for investors with a long-term investment horizon – and we recommend cyclical plays like commodities, corporate bonds, infrastructure stocks, and defense stocks in our strategic portfolio. We also recognize that if key cyclical and reflation indicators break out from here, then a cyclical bull market could take shape. Yet our analytical framework reveals that recession and mega-stimulus have diminished the financial and economic constraints that would normally deter geopolitical actors from ambitious actions on the international stage. Most notably, the US election dynamic has turned upside-down. President Trump is the underdog and will need to develop a reelection bid that does not hinge on the economy. Doubling down on “America First” foreign policy and trade policy makes the most sense and the ramifications are negative for the markets over the next five months. This is the key dynamic that makes US-China, US-North Korea, US-Russia, and US-Iran tensions more market-relevant than they would otherwise be. It also will dampen an otherwise positive story for the euro, in the short run.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Section II: Appendix : GeoRisk Indicator China: Russia: UK: Germany: France: Italy: Canada: Spain: Taiwan: Korea: Turkey: Brazil: Section III: Geopolitical Calendar

Highlights This year’s NPC refrained from announcing a numeric economic growth target. However, the targeted employment growth will be a reliable indicator of the government’s pain threshold.  The announced stimulus package did not exceed market expectations.  At the same time, the government is keeping the liquidity tap open and the fiscal budget flexible.  We expect the government to utilize both policy tools before July. The stimulus focuses on supporting infrastructure investment and consumption, with marginal loosening of property market restrictions. While we maintain a positive view on Chinese equities in the next 6 to 12 months, we favor large cap stocks in domestic demand-driven sectors, to hedge rising geopolitical risks. We also recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. Feature This year’s National People’s Congress (NPC) delivered two surprises on opening day: a new national security bill on Hong Kong SAR, which will be voted on at the May 28th plenary session;1 and a lack of an annual economic growth target in the Government Work Report (GWR), for the first time since the early 1990s. Chinese stock prices in both the onshore and offshore markets plunged following Friday’s NPC session (Chart 1). Chart 1Messages From This Year's NPC Did Not Bode Well For Market Sentiment Numeric targets in the stimulus package announced at the NPC did not exceed the consensus.  However, citing global geopolitical and economic uncertainties, Chinese policymakers have kept the liquidity tap open and the fiscal budget flexible. This means that policymakers can add to the existing stimulus without the approval of the NPC at the Politburo’s mid-year review in July.  Investors will likely turn their focus back to economic fundamentals in the coming months. In Q2, the market will trade on the back of disappointing corporate earnings and news from the geopolitical front. In H2, however, a confluence of further domestic policy easing and a global economic recovery should lift Chinese corporate earnings. As such, our cyclical (6-12 months) outlook on both China’s economic recovery and equity performance remains upbeat. The Economy: No Growth Target ≠ No Growth The GWR set targets for this year’s urban job creation and unemployment rate, even though it refrained from setting an explicit objective for economic growth in 2020 (Table 1). A numeric target on job growth implicitly provides a floor to the economy, i.e., stimulus will have to step up if the economy does not provide adequate jobs to meet the employment target. Table 1No Growth Target, But Big Spending Anecdotes indicate that, to keep the unemployment rate in abeyance, the government has mandated corporations to retain their employees on payrolls even if there is no pay. This may help to explain the meager 6.0% unemployment rate in China compared with a near 20% rate in the US. It is undoubtedly much harder to create new jobs than to maintain a stable unemployment rate. Economic and demand growth is still the foundation for job growth, and administrative measures can only go so far in creating new jobs, particularly in the private sector. The government pledges to create 9 million new jobs in 2020, about 20% lower than the target of 11 million new jobs set for last year. In 2019, 13.52 million urban jobs were created and the nominal GDP expanded at 7.8%. A back-of-the-envelope calculation suggests that China economy needs to grow by 4-5% from 2019 (in nominal terms) to achieve the employment target for this year. Given that Q1 registered a 5.3% contraction, China’s economy must expand by at least 8% (year on year) in H2 (Chart 2). Chart 2Employment Growth Will Be This Year's Government Policy Anchor Stimulus: Keeping Options Open “We will use a variety of tools such as required reserve ratio reductions, interest rate cuts, and re-lending to enable M2 money supply and aggregate financing to grow at notably higher rates than last year.”  – Li Keqiang at the NPC, May 22, 2020. Chart 3Further Monetary Easing Likely In June This statement makes it clear that policymakers intend to keep the liquidity tap running. The easing of local government financing vehicle (LGFV) borrowing and shadow banking regulations also indicates that Chinese policymakers have given an all-clear signal to accelerate money and credit growth. We expect another round of cuts in interest rates and required reserve rates ahead of the July Politburo meeting.  The credit impulse should reach around 35% of China's GDP this year, well above the 25% in 2019 (Chart 3). A notable exception in this year’s GWR is that it did not put a lid on the size of fiscal stimulus. The fiscal deficit for 2020 is set at an ambiguous “above 3.6% of GDP”. Furthermore, the GWR states that the current policies “can be improved according to changes in the economic situation,” which will allow for greater leeway in easing. We believe that while the government pledges to maintain a measured stimulus, more easing actions are inevitable. China’s post-pandemic economic recovery is on track and not yet close to the policymakers’ pain threshold. However, the global economy faces tremendous uncertainties.  The pandemic is not yet controlled worldwide and the US-China rivalry is expected to grow more acrimonious in the months to come. A temporary setback in China’s economic recovery and financial market in Q2 is a strong possibility. Employment is also set to come under more pressure in Q2 when an estimate of 8.7 million new college graduates enter the job market. As mentioned in our previous report, China’s job losses so far are concentrated in lower-skilled, lower-income manufacturing and service sectors.2 However, the new graduates will seek middle-income, white-collar jobs, which can only be provided by real demand in the economy. Young middle-class professionals in China are not only a major source of consumption growth, but also are a source of domestic instability if they are discontent – a political risk we do not think the Chinese leadership is willing to take. Fiscal Stimulus: Largest On Record Raw material prices have closely tracked Chinese credit cycles since the Global Financial Crisis (GFC). China’s fiscal impulse and government-led investment have helped to speed up commodity price recoveries and bridged the gap between economic slowdowns and a rebound in the private sector (Chart 4). Fiscal deficit will likely be enlarged by more than 3% of GDP in 2020 from last year's near 5% of GDP, and will be the largest annual deficit increase on record. The announced budgetary fiscal deficit in 2020 is set at above 3.6% of GDP, but the broad-measure fiscal deficit will most likely reach to more than 8% of GDP this year when taking into account both government budgetary and fund expenditures (Chart 5). Chart 4Commodity Prices Will Get A Lift From Fiscal Stimulus Chart 5Fiscal Deficit Largest In Decades Chart 6"New Infrastructure" Investment Moved Into The Fast Lane The local government special purpose bond (SPB) budget is set at 3.75 trillion, 1.6 trillion above last year. We expect 80% of the 2020 SPB to be invested in infrastructure projects. With the additional 700 billion yuan of central government budgetary investment fund, infrastructure investment will be increased by 2.5 trillion compared with 2019, a 10% growth (Chart 6). A reason why the market reacted negatively to the announced stimulus is that the headline figure for central government special treasury bonds (STB) is below market expectations. However, STBs are special transfers from the central government to localities to replenish fiscal reserve funds, which have little stimulative impact on business activity. The fact that the figure is below market expectations does not have the same kind of market relevance as government expenditure or local government SPB. Real Estate: More Dovish Chinese policymakers have always maintained an enigmatic attitude towards the housing sector. Although no housing stimulus was announced this year, the tone on keeping housing demand in check has softened. Phrases have been added to this year’s GWR, allowing provincial and city officials to adjust their housing policies. Housing policy has become progressively less restrictive since mid-2019 and we anticipate some modest property stimulus going forward. Chart 7Construction Set To Pick Up As mentioned in our previous reports, the massive contraction in fiscal revenue growth this year will inevitably push up land auctions and housing construction activity (Chart 7). We continue to expect a strong recovery in housing demand, particularly in China’s top-tier cities. Lower mortgage rates, easier access to bank loans and the preference to hold hard assets to hedge inflation, all will drive up housing demand among higher-income Chinese households. High-frequency data show that since the beginning of May, the contraction in property sales in tier-1 and tier-2 cities have narrowed by 17 percentage points from April.  Investment Conclusions The NPC delivered a stimulus package that did not exceed market expectations, which means that investors will be re-focusing on China’s economic fundamentals in the near term.  We think that geopolitical tensions and weak corporate earnings will dominate the performance of equities in Q2.  On the geopolitical front, Beijing’s move to pass a new national security law on Hong Kong will likely be met with retaliatory actions from the US, adding fuel to the US-China tensions. The near-term response in the equity market will be negative if President Trump follows through with his retaliatory threats. Consequently, we recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. On China’s domestic economy, industrial profit growth will likely remain in contraction during most of Q2, before returning to modest positive growth in H2. As such, near-term investors’ risk appetite will experience periods of setbacks, and there will be better price entry points to go long on Chinese stocks in both relative and absolute terms. We remain positive on Chinese equities in the next 6 to 12 months. The speed of the economic recovery will likely accelerate in H2, and there is a distinct possibility that the stimulus will step up following a lackluster economic recovery in Q2. Some cyclical industries will significantly benefit from the ongoing stimulus and recover ahead of the broad market. We favor consumer discretionary stocks in both onshore and offshore equity markets.3 We also recommend that investors focus on large cap firms that draw their revenues from domestic demand-oriented industries. This will help to hedge volatilities created from escalating US-China trade frictions.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 We will discuss the implications from the Hong Kong national security bill proposal in future research. 2 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com 3 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

An analysis on Turkey is available below.   Highlights Due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions between the US and China will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. The RMB is set to depreciate dragging down emerging Asian currencies. There is evidence that the equity rally from late-March lows has been driven or supercharged by retail investors worldwide. Such retail-driven manias never end well, though they can last for a while. Feature Emerging market equities are facing a critical technical resistance. Chart I-1 shows that over the past decade, EM share prices often found support at the horizontal line during selloffs. The latter could now become a resistance point. In turn, the Australian dollar and the S&P 500 have climbed to their 200-day moving averages (Chart I-2). Chart I-1EM Stocks Are Facing A Technical Resistance Chart I-2S&P 500 And AUD Are At Critical Technical Juncture   Having rallied strongly in the past two months, it is reasonable to expect that global risk assets will take a breather as investors assess the economic and geopolitical outlooks. China: Aggressive Stimulus… China has embarked on another round of aggressive stimulus. The government program approved by the National People’s Congress (NPC) last week laid out the following macro policy objectives: Stabilize employment. The NPC has pledged to create more than 9 million new jobs in urban areas. Although this is lower than last year’s target of more than 11 million new jobs, it is very ambitious given the number of layoffs that have occurred year-to-date. Chart I-3China: Money/Credit Is Set To Re-Accelerate Significantly accelerate the growth rate of broad money supply and total social financing relative to last year. Indeed, broad money growth accelerated in April and will continue to move higher (Chart I-3). Lending to enterprises and households as well as overall bank asset growth have all accelerated (Chart I-3, bottom two panels). Boost aggregate government spending (budgetary and quasi-fiscal) growth to 13.2% in 2020 versus 9.5% last year.   Local government’s special bond quotas have been set at RMB 3.75 trillion yuan, compared with RMB 2.15 trillion last year. The central government will issue special bonds in the order of 1 trillion yuan. The proceeds will be transferred to local governments to support tax and fee reductions, as well as to boost consumption and investment.  Support SMEs. The government will extend its beneficial loan-repayment policy for SMEs until March 2021. It will extend exemptions for SMEs on social security contributions, VAT and other fees and taxes through to the end of this year. The government estimates a total of RMB 2.5 trillion in tax and fee reductions for companies in 2020. Table I-1 details potential scenarios for the credit and fiscal spending impulse (CFI). In our baseline scenario, the CFI will rise to 15.5% of GDP by year-end (Chart I-4). In short, in 2020 the CFI will likely be larger than it was in 2015-’16 and closer to its 2012 level. However, it will still fall short of the 2009-2010 surge. Table I-1Simulation On Credit And Fiscal Spending Impulse For 2020 Chart I-4Our Projections For The Credit And Fiscal Spending Impulse In summary, it is fair to say that for now, the authorities have abandoned their deleveraging objective and are encouraging a substantial acceleration of both debt and credit. However, it will take time before the stimulus filters through the economy and boosts growth. This will be the case because of the following persistent headwinds: First, the reduced willingness of households and enterprises to spend. The top panel of Chart I-5 reveals that consumers’ marginal propensity to spend is falling. Enterprises’ willingness to invest continues to trend lower. Historically, companies’ willingness to invest has been a good indicator for industrial metals prices. So far it has not validated the advance in base metals (Chart I-5, bottom panel). The rationale for this correlation is that Chinese companies account for 50-55% of global industrial metals demand. Second, the COVID-19 economic downturn in China was much worse than previous downturns, and the financial health of companies and households is considerably poorer than before. This is why it will take very large amounts of stimulus to produce even a moderate recovery. In particular, a portion of the credit expansion will go toward plugging operating cash flow deficits at companies rather than to augment investment. For example, in the US, commercial and industrial loan growth surged in 2007/08 and this year (Chart I-6). In all of those cases, the underlying cause for credit acceleration was companies drawing on their credit lines to close their negative operating cashflow gaps. Chart I-5China: Households And Enterprises Are Less Willing To Spend Chart I-6US Loan Growth Spikes In Recessions The same phenomenon is presently occurring in China. This entails more credit origination will be required in China in this cycle before we witness a revival in capital spending. Third, geopolitical tensions between the US and China will escalate further in the months ahead. We elaborate on this in more detail below. As far as China’s growth outlook is concerned, rising geopolitical tensions with the US will weigh on both consumer and business confidence. On the whole, due to the sizable stimulus announced by the NPC, we are upgrading our outlook for Chinese growth for this year. Nevertheless, in terms of investment strategy, we are reluctant to chase China-related plays higher at the moment. Rising geopolitical tensions will likely produce a pullback in China-related risk assets, providing a better entry point in the months ahead. Chart I-7Chinese Economy: Still Very Weak In addition, the mainland economy is still undergoing post-lockdown normalization – not recovery. Both capital spending and household consumption are still in recession (Chart I-7).    Bottom Line: China is yet again resorting to aggressive fiscal and credit stimulus. Mainland growth is bound to improve over the remainder of the year. However, financial markets have run a bit ahead of themselves, and we will wait for a pullback before recommending China-related plays.  …But Geopolitics Is A Major Risk Despite an improving growth outlook, Asian and China-related risk assets could struggle in the months ahead due to escalating geopolitical tensions between the US and China. On the surface, the COVID-19 crisis seems to be the culprit behind rising tensions between the two nations. However, the pandemic has only accelerated an otherwise unavoidable confrontation between the existing superpower and the rising one. BCA’s Geopolitical Strategy team has been writing about cumulating tensions and the potential for them to boil over in the months before the US election. The contours of the rise in geopolitical tensions will be as follows: President Trump’s chances of re-election have declined, with the recession gripping the US economy and unemployment surging. There is little doubt that he will use external foes to rally the nation behind the flag. Blaming China for the pandemic and acting tough is probably the only way for Trump to switch his campaign’s nucleus from the economy to foreign policy, which will raise the odds of his election victory. The US administration will not resort to import tariffs this time around. Going forward, the administration’s goal will be cutting China’s access to foreign technology. Technology in general and semiconductors in particular will be the key battleground in this new cold war. The US will also step up its pressure on multinationals to move production out of China. The broader idea is to impede China’s technological advance. Even though the US rhetoric on China’s policies toward Hong Kong will be tough, there is little the US can do or will do regarding Hong Kong. Rather, the more important battleground will be Taiwan and its semiconductor industry. Finally, China’s political leadership cannot tolerate being perceived as weak domestically in the face of US pressures. They will retaliate against the US. One form of retaliation against Trump could be pushing North Korea to test its strategic military weapons that could undermine Trump’s foreign policy credibility in the US. Another form of retaliation could be tolerating moderate currency depreciation. The latter will challenge Trump’s claims that he has been victorious in dealing with China. The latest decision to ban US and foreign companies from accepting orders from Huawei and the slide in the value of the RMB are consistent with these narratives. To our surprise, however, financial markets in general and Asian markets in particular have not sold off meaningfully in response to the US ban on Huawei and renewed RMB depreciation. Critically, China is the world’s largest consumer of semiconductors, accounting for 35% of global semiconductor demand. Restricting Chinese purchases would be negative for global semiconductor producers. China has been aware of the risk of US restrictions on its imports of semiconductors and has been ramping up its semi imports since 2018. Semi imports have been booming even though smartphone sales had been shrinking (Chart I-8). This is a sign of large semiconductor restocking in China which has helped global semi sales in general and TSMC sales in particular in the past 18 months. In brief, major semi restocking by China in the past 18 months along with the ban on sales to Huawei all but ensure that global semiconductor sales will be weak this year. It does not seem that global semi stocks in general and Asian ones in particular are pricing in this outcome. Global semiconductor stocks are a hair below their all-time highs, and their trailing P/E ratio is at 21. Specifically, given Huawei is the second-largest customer of TSMC, the latter’s sales will be negatively affected (Chart I-9). Chart I-8Has China Been Stockpiling Semiconductors? Chart I-9TSMC Has Benefited From China Stockpiling Semiconductors Finally, both DRAM and NAND prices are falling anew (Chart I-10). Further, DRAM revenue proxy correlates with Korean tech stocks and points to lower share prices (Chart I-11). Chart I-10Semiconductor Prices Have Begun Falling Chart I-11Semiconductor Prices Are Still Deflating DRAM Revenue Proxy And Korean Tech Stocks Crucially, Chinese, Korean and Taiwanese stocks account for 60% of the MSCI EM equity market cap. Hence, a selloff in these bourses will weigh on the EM equity index. Chart I-12 shows that the latest drawdown in these North Asian equity markets was relatively small compared to the drop in the rest of the EM equity universe. Hence, Chinese, Korean and Taiwanese share prices are not discounting a lot of bad news making them vulnerable to the geopolitical risks that lie ahead. Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. Chart I-12North Asian Stocks Versus The Rest Of EM Bottom Line: Financial markets in Asia are very complacent to mounting geopolitical risks stemming from the US-China confrontation. The RMB is set to depreciate dragging down emerging Asian currencies. The large share of Chinese, Korean and Taiwanese stocks in the MSCI EM equity index implies significant downside risks to the EM equity benchmark. The Global Economic Outlook As economies around the world open, the level of economic activity will certainly begin to rise. The opening of shops, offices and various other facilities will result in a partial normalization and an increase in economic activities.  However, we cannot call this a recovery. Rather it is just a snapback from the lockdowns which both equity and credit markets have already fully priced in. The outlook for global share prices and credit markets depends on what happens to the global economy following this post-lockdown snapback. Will the snapback be followed by an actual recovery or will the level of activity stagnate at low levels? For now, our sense is that following the initial snapback a U-shaped recovery is the most likely global scenario. This does not exclude the possibility that activity in some sectors/countries will follow a square root trajectory.  From a global macro perspective, we have the following observations to share: Certain industries will likely experience stagflation. Due to social distancing measures, they will be forced to limit their output/capacity and compensate for their increased costs by charging higher prices. In this group, we would include airlines, restaurants, and other service sector businesses. The short-term outlook for consumer spending is contingent on fiscal stimulus. A material reduction in fiscal support for households will weigh on their spending capacity. Capital spending will remain subdued outside China’s stimulus-driven local government and SOE investment outlays, and outside the technology sector, generally. Critically, economic activity in many countries and industries will remain below pre-pandemic levels until late this year. This implies that despite the snapback, some businesses will still be operating below or close to their breakeven points. This will have ramifications on their ability to service debt and on their willingness to invest and hire. Any rise in government bond yields worldwide will be limited as central banks in both DM and EM will cap yields by augmenting their purchase of government and in some cases corporate bonds. We discussed EM QE programs in detail in last week’s report. Bottom Line: It is tempting to interpret the post-lockdown snapback in economic activity as a recovery. However, the nature and depth of this recession is unique. Investors should consider both the direction of economic indicators and the level of economic activity in relation to a company’s breakeven point. This is an extremely difficult task. And that is in addition to gauging the odds of a second wave of COVID-19 infections later this year. In the context of such complexities facing investors, there is astonishing evidence that the recent equity rally has been driven by unsophisticated retail investors. A Retail-Driven Equity Rally There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. There is growing evidence that the equity rally from late-March lows has been driven or supercharged by retail investors, worldwide. Such retail-driven manias never end well, though they can last for a while. The following articles corroborate the worldwide phenomenon that retail investors have been opening broker accounts en masse and investing in stocks: Bored Day Traders Locked at Home Are Now Obsessed With Options Frustrated sports punters turn to US stock market Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing It is fair to assume that retail investors do very little fundamental analysis. Not surprisingly, since March global share prices have decoupled from profit expectations. Although some professional investors have no doubt also played the rally, surveys of asset managers and traders suggest that generally they have stayed lukewarm on stocks. Specifically, the net long position of asset managers and leveraged funds in various US equity index futures remains very low (Chart I-13). Chart I-14 shows that US traders’ and professional individual investors’ sentiment on US stocks are at multi-year lows. Only US investment advisors have become fairly bullish again (Chart I-14, bottom panel). Chart I-13Fund Managers Have Stayed Lukewarm On Stocks Chart I-14Professional Investors’ Sentiment On Stocks Have Been Subdued Who will capitulate first: retail or professional investors? It is hard to predict the behavior of investors but, if we had to guess, our take could be summed up as follows:  If geopolitical tensions escalate much more or the number of COVID-19 inflections in some large countries rises anew, retail investors will likely sell before professional investors step in. In this scenario, share prices will drop considerably. In the case of an absence of geopolitical tensions or a new wave of infections, it is hard to see how economic data that is improving could lead to a substantial drawdown in equities even if the level of activity remains very depressed. In this case, corrections will be small and short-lived. Investment Strategy Chart I-15Beware Of Breakdowns For global equity portfolios, we continue recommending underweighting EM stocks. Regardless of the direction of global share prices, EM will continue underperforming DM (Chart I-15, top panel). The basis for this is rising geopolitical tensions in China and weakness in the RMB will spill over into other emerging Asian currencies (Chart I-15, bottom panel). We continue recommending short positions in the RMB and KRW versus the US dollar. In terms of the absolute performance of EM equities and credit markets, as well as EM currencies versus the greenback, we recommend being patient. Global and EM financial markets are presently at a critical juncture, as illustrated in Charts 1 and 2 on pages 1 and 2. If these and some other markets meaningfully break above current levels of resistance, we will upgrade our stance on EM stocks and credit markets and close our short positions in EM currencies versus the US dollar. If they fail to do so, a considerable selloff is likely to follow. As to EM local currency bonds, we are long duration but cautious on EM currencies. For the full list of our recommendations for EM equity, credit, local fixed-income and currency markets, please refer to pages 18 and 19.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Lin Xiang, CFA Research Analyst linx@bcaresearch.com     Turkish Lira: Facing A Litmus Test The Turkish lira has rolled over at its resistance level on a total return (including carry) basis (Chart II-1). The spot rate versus the US dollar is at its 2018 low. In short, the exchange rate is facing a litmus test. The culprit of a potential downleg in the lira is an enormous monetary deluge. Chart II-2 reveals that broad money supply growth has accelerated to 35% from a year ago. Local currency money supply is skyrocketing because the central bank and commercial banks are engaged in rampant money creation and public debt monetization. Chart II-1Turkish Lira (Including Carry): A Good Point To Short Chart II-2Turkey’s Broad Money: The Sky Is The Limit While such macro policies could benefit economic growth in the short term, they also herald growing inflationary pressures and currency devaluation. First, Turkish commercial banks have been on a government bonds buying binge since 2018 (Chart II-3, top panel). They presently own 62% of total local currency government bonds, up from 45% in early 2018. In addition, the central bank is de-facto engaging in government debt monetization. The Central Bank of Turkey (CBT) has bought TRY 40 billion of government bonds in the secondary market since March (Chart II-3, bottom panel). When a central bank or commercial bank buys a local currency asset from a non-bank, a new local currency deposit is created in the banking system and the money supply expands.  Chart II-3Turkey: Public Debt Monetization In Full Force Chart II-4Turkey: Loan Growth Exceeds 30% Second, the commercial banks’ local currency loan growth has surged to 32% (Chart II-4). Government lending schemes and newly introduced regulations are incentivizing commercial banks to continue lending in order to boost domestic demand. In particular, state owned banks are providing loans at interest rates well below both the policy and inflation rates. The most likely outcome from such policies is rampant capital misallocation and an increase in non-performing loans. The former will weigh on productivity in the long turn. Third, the central bank has been providing enormous amounts of liquidity to commercial banks (Chart II-5, top panel). The latter’s local currency excess reserves – which are exclusively created out of thin air by the central bank - have surged (Chart II-5, bottom panel). In fact, the effective policy rate has been hovering below the actual policy rate, suggesting that there is an excess liquidity overflow in the banking system. In a nutshell, the central bank has been providing fuel to commercial banks to expand money supply via the purchases of local currency government bonds and loan origination. Fourth, an overly loose monetary stance will lead to higher inflation and currency devaluation. Moreover, wages continue to expand at an annual rate of 15-20%, confirming the fact that inflationary pressures are genuine and broad within this economy (Chart II-6). Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Chart II-5Central Banks' Liquidity Provision To Banks Chart II-6Turkey: A Sign Of Genuine Inflation Higher inflation, and the consequent loss of purchasing power, is leading residents to switch their holdings of liras to foreign currencies. Finally, Turkey’s current account deficit is set to widen, and the central bank’s net foreign currency reserves are non-existent at best. Booming credit growth will keep domestic demand and imports stronger than they otherwise would be. In the meantime, the complete collapse in tourism revenues and Turkey’s large foreign debt obligations, estimated at $160 billion over the next six months, entail negative balance of payment dynamics. Barring capital controls, Turkey will not be able to preclude further currency depreciation. Investment Implications Short the Turkish lira versus the US dollar. We recommend dedicated equity investors underweight Turkish equities and credit relative to their respective EM benchmarks. Also, we are reiterating our short Turkish banks / long Russian banks position. Local currency yields will offer little protection against currency depreciation. As such, investors should underweight domestic bonds.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations