Financial Markets

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The tech sector is in a manic phase. This mania has further room to run because inflation will remain low for at least the next two years and global central banks will maintain very easy policy conditions, which will cap the upside in bond yields. Tech will have its day of reckoning when inflation can rise and the sector’s weight will drag down the market. Bubbles are prone to severe corrections; this one is no exception. In the near term, tech earnings will probably miss lofty embedded expectations. The falling dollar is a problem for the sector and the election season introduces great risks. In the near term, inflation breakeven rates, the silver-to-gold ratio and the deep cyclicals-to-defensives ratio will all rise further. Industrials have a window to outperform technology. Feature The S&P 500 continues its ascent, increasingly driven higher by surging tech stocks. The extreme resilience of a few tech titans has resulted in an incredibly concentrated equity market, in which the capitalization of Google, Amazon, Microsoft, Apple and Facebook equals that of 224 deep and early cyclical stocks in the S&P 500. Such a narrow market raises three questions: is the tech sector in a bubble? What will pop this bubble? If the tech bubble bursts, will the S&P 500 shrug it off or decline with giant technology firms? We believe that tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative, despite occasional pullbacks. Moreover, the broad market will suffer when the bubble eventually bursts. Each Decade Has Its Bubble BCA Research’s Emerging Market Strategy team recently demonstrated that each decade in the past 60 years has experienced its own financial excess (Chart I-1).1 Three forces fueled each of these manias: an extended phase of easy monetary policy; a narrative that drove funds towards fashionable assets; and an extended period of superior returns that accentuated the inevitability of participating in the bubble. Chart I-1Each Decade Has Its Bubble In the 1960s, the mania surrounded the so-called “Nifty 50” stocks, as exemplified by Disney. The Nifty 50 were large-cap companies with solid franchises and a proven track record of dividend growth. Meanwhile, the period of low inflation from 1960 to 1966 allowed the US Federal Reserve to keep the unemployment rate below NAIRU, which indicated that policy was accommodative. When inflation began to rise in 1966, the Fed lifted interest rates to 7.75% in 1973, and the bubble evaporated with the recession started that year. In the 1970s, the mania involved precious metals, such as gold and silver. Precious metals benefited from the 33% fall in the dollar, the surge in inflation from 2.9% in 1970 to 14.7% in 1980, and the Fed’s incapacity to get ahead of the inflation curve through most of the decade. Then-Fed Chair Paul Volcker burst this bubble when he boosted interest rates to 19% in 1981 to kill off inflation, which also started the 93% dollar rally that culminated in 1985. Tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative. In the 1980s, the mania centered on Japan. The Japanese economy experienced a miraculous post-war expansion, with real GDP per capita surging by a cumulative average growth rate of 7% between 1945 and 1980. By the mid-1980s, the prevailing belief was that Japanese firms would dominate every industry. Moreover, after the Ministry of Finance allowed the yen to surge following the September 1985 Plaza Accord, the Bank of Japan (BoJ) cut interest rates by 2.5%, creating very easy domestic monetary conditions. This lax policy setting unleashed a surge in credit and asset valuations that pushed up the Nikkei-225 five times by the end of the decade and resulted in an 860% increase in the value of Japanese banks. The BoJ lifted interest rates by 3.5 percentage points between 1987 and 1990. The market peaked in December 1989 and the Nikkei collapsed by 82% during the next 19 years. In the 1990s, tech stocks and the NASDAQ captured investors’ imagination. The internet, computing power and software, all drove an increase in productivity growth to a two-decade high and investors understood that the sector’s earnings prowess was only beginning. Moreover, as inflation fell through the 1990s, then-Fed Chairman Alan Greenspan kept policy rates more or less flat for four years before cutting the fed funds rate by 75 basis points in 1998. Additionally, around the turn of the millennium, the Fed increased the size of its balance sheet by $90 billion as a precautionary measure against Y2K. Consequently, with the ensuing euphoria, investors pushed the NASDAQ’s valuation to a P/E ratio of 72, extrapolating far into the future much-too-strong earnings growth. The bubble imploded when the Fed normalized policy. We are not even thinking about thinking about raising rates. In the 2000s, the dominant story was the unstoppable upswing of the Chinese economy, the nation’s rapid urbanization and insatiable thirst for commodities. The lack of investment in commodity extraction through the 1990s exacerbated the rally in natural resources. The easy Fed policy implemented in the wake of the tech crash of 2000 to 2003, and the dollar’s 40% plunge between 2002 and 2008 added to the bullish mix in favor of resources. Commodity indices surged and iron ore, which derives a particularly large share of demand from construction in China, increased 12-fold between 2000 and 2011. The rise in the broad trade-weighted dollar that began in 2011 along with a slowdown in Chinese growth initiated in 2010 ultimately quashed commodities. Is The Tech Bubble About To End? Chart I-2The Drivers Of The Tech Bubble Historically, bubbles often abort at the end of the decade in which they materialize. Will the ongoing mania suffer the same fate as its predecessors? For now, the pillars of the tech bubble remain intact. The strength of tech stocks reflects both their superior ability to generate cash flow growth and the structural decline in bond yields (Chart I-2). It is easy to understand why superior cash flow growth would result in strong tech performance, but the role of lower yields is not obvious. Tech stocks derive a large proportion of their intrinsic value from long-term deferred earnings and the terminal value of those cash flows. These distant profits are sensitive to fluctuations in the discount rate and, therefore, their present value soars when bond yields fall. The ability of tech to generate expanding earnings remains intact. Companies have curtailed capital expenditures due to the COVID-19 crisis, but they continue to spend on their software and hardware needs (Chart I-3). The growing prevalence of work-from-home arrangements and the proliferation of global cyberattacks (see Section II) will only feed the tech sector’s profit outperformance. Crucially, easy money and low interest rates will endure for an extended period. As Fed Chair Jerome Powell stated, “We are not even thinking about thinking about raising rates.” Our BCA Fed Monitor confirms this message (Chart I-4). Chart I-3Robust Tech Spending Chart I-4Easy Money As Far As The Eye Can See   Chart I-5Inflation Is The Tech Slayer Ultimately, much will depend on inflation. As BCA Research’s Equity Sector Strategy service recently demonstrated, the tech sector abhors rising inflation.2 Even during the seemingly unstoppable technology surge in the 1990s, the sector’s outperformance ended following an increase in core CPI (Chart I-5). Tech’s business model is optimized for deflationary conditions, especially when compared with other cyclical industries. Moreover, rising inflation puts upward pressure on interest rates and ultimately requires greater real interest rates to control accelerating CPI increases. Climbing real interest rates disproportionally hurt growth stocks, due to their heightened sensitivity to discount rates. Inflation will stay low as long as the labor market remains far from full employment. The slow progress in employment indicators suggests that the unemployment rate will be above NAIRU for at least two to three years (Chart I-6). Moreover, our Global CPI diffusion Index is also consistent with extended muted inflation (Chart I-7, top panels). The slowdown in money velocity and the weakness in the demand (as approximated by the smoothed growth rate of retail sales relative to average weekly earnings) will only exacerbate low inflation in the coming year or two (Chart I-7, bottom panels). Chart I-6Far From Full Employment Chart I-7For Now, Disinflation Dominates   In this context, valuations have room for more expansion. The NASDAQ may be pricey, but it is far from the 1990s’ nosebleed levels when nominal 10-year yields stood at 6.8% compared with today’s 0.55%, and 10-year TIPS yielded 4.3% and not their current -0.9%. In effect, both the equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. The equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. Finally, investors have largely missed the rally in stocks, which implies that a large proportion of the gains in tech stocks have not accrued to many investors. Since 2010, companies have been the main buyers of stocks while households and pension plans have constantly sold the asset class (Chart I-8). Additionally, investor sentiment remains firmly bearish and cash holdings of investors and households have surged in the wake of the COVID-19 pandemic (Chart I-9). Thus, there is a lot of pent-up demand for financial assets. TINA (‘there is no alternative’) will invite investors to pour funds into equities with 10-year yields stuck near 0.6% and short rates at zero. Tech stocks will benefit from this trend. Chart I-8Households And Pension Plans Have Divested Chart I-9Not A Generalized Euphoria...     Practical Considerations For Investors Bubbles are highly dangerous for investors. A lack of participation in a mania often results in disastrous underperformance for institutional investors, but staying invested in the bubbly asset too long can be even more lethal for a portfolio’s performance. This dichotomy means that as long as there is low inflation and accommodative policy, we cannot underweight or overweight tech stocks. BCA Research’s equity strategists are neutral on tech, but within the sector they overweight the more defensive software and services components relative to the high-beta hardware and equipment industry groups.3 Three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Another risk inherent to bubbles is that they are often volatile; the current tech exuberance will not be different. In the second half of the 1990s, the NASDAQ experienced ten 10% or more corrections and tumbled by more than 20% in 1998 before leaping to new highs. Currently, we monitor three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Risk 1: Tech Earnings Do Not Meet The Hype Chart I-10...But A Localized Euphoria Today, tech stocks are vulnerable to a sharp pullback because investors are willing to bid up these shares in light of their perceived high growth rate (Chart I-10). This sector-specific euphoria increases the likelihood that if second-quarter tech earnings disappoint, then a significant correction will occur in widely held companies. The stock prices of Microsoft, Netflix and Snapchat have been punished following disappointing Q2 results. Retail investors indirectly amplify the risk created by potential earnings disappointments. Users of free trading apps (e.g.: Robinhood) are the marginal buyers, but more importantly their order flows are sold to large institutional houses who front-run these small players. Large investors with immense buying power can swing the price of the stocks popular with retail investors. Hence, when small investors unload due to bad news, a selling deluge ensues. Risk 2: A Weak Dollar Tech stocks thrive with a strong dollar because it is synonymous with low inflation and low yields. Consequently, a rising USD puts upward pressure on tech multiples. Moreover, a depreciating dollar is linked to robust global growth, which lifts the earnings prospects of other deep cyclical stocks more than tech equities, hurting the latter’s relative performance. The US election also creates a serious risk for tech stocks. The dollar is falling prey to a confluence of factors. The outlook for the US balance-of-payments is deteriorating sharply as the twin deficit explodes higher. Moreover, the national savings rate will remain in a downtrend after 2020 (Chart I-11). The US fiscal deficit will narrow from its current level of at least 18% of GDP, but it will not return for many years to the 4.6% of GDP that prevailed in 2019. The unemployment rate will stay above NAIRU for at least two to three years and the median voter increasingly favors economic populism. These two forces will generate high levels of spending. Meanwhile, a negative nominal output gap will weigh on tax revenues. Concerning private savings, the household savings rate will normalize from its April high of 33% of disposable income because consumer confidence will improve, thanks to strong consumer balance sheets and a limited decline in household net worth (Chart I-12). Chart I-11Vanishing US Savings Chart I-12Household Balance Sheets Are Alright   Chart I-13Forget The Breakup Songs For Now A poor balance of payments would not be a hurdle for the dollar if US real interest rates were high and foreign investors had confidence in the US economy, but neither of these conditions exists. US real interest rates have fallen relative to the rest of the world and the economic impact of the second wave of COVID-19 infections in the US partly explains the strength in the euro. Moreover, the recently agreed EUR750 billion of common bond issuance by the EU will curtail the probability of a euro breakup, which will compress European risk premia (Chart I-13). This development is highly positive for the euro, which could quickly move toward the 1.20 to 1.25 zone. The global economic recovery amplifies the negative impulse for the dollar. We have often argued that the USD is a countercyclical currency (Chart I-14).4  Hence, the recent uptick in Chinese stimulus and the positive outlook for the global industrial cycle bodes poorly for the US dollar. Moreover, a weak dollar can unleash a feedback loop that supercharges global growth. According to the Bank for International Settlements, foreign issuers have emitted $12-$14 trillion of USD-denominated liabilities. A weak dollar would diminish the cost of servicing this debt and ease global financial conditions, which would boost the world’s economic outlook. The brightening outlook would further feed the dollar’s weakness and underpin its momentum behavior (Chart I-14, bottom panel). Shifting international flows create the last major headwind for the US dollar. Fund repatriation by US economic agents has been a critical driver of the dollar since 2014. The USD rallied in tandem with a surge of repatriation in the wake of the Tax Cuts and Jobs Act of 2017, despite the lack of appetite for US assets by foreigners (Chart I-15). Now that the effect of the tax cuts has passed, repatriations are dwindling from their 2019 peak. Meanwhile, foreign investors’ appetite for dollar assets is not returning, especially as flows into US Treasurys are collapsing (Chart I-15, bottom panel). Chart I-14The Dollar Feedback Loop Chart I-15Flows Are Turning Against The Greenback   The dollar’s recent rally runs the risk of a short-term pause. Our USD Capitulation Index is at a level consistent with a short-term rebound (Chart I-16). Nonetheless, the list of dollar-bearish factors noted above suggests that any rebound in the dollar would be temporary. Risk 3: The Election Run-Up The US election also creates a serious risk for tech stocks. President Trump’s approval rating remains in tatters despite the vigorous rebound in equities since March 23 (Chart I-17). His support at this stage of the presidential cycle clearly lags that of previous presidents who were re-elected (Chart I-17, bottom panel). Consequently, our Geopolitical Strategy team assigns a subjective probability of 35% that he will remain in the White House next January.5 This creates two problems for investors. When cornered, President Trump often lashes out at foreign economies, which leads to geopolitical tensions. The heated rhetoric toward China will likely worsen in the coming three months, which raises the prospect of another leg in the US-Sino trade war, with negative effects for tech firms that extract 58% of their revenues from abroad. Furthermore, if former Vice-President Joe Biden clinches the presidency, then the Senate will turn Democrat. The Democrats will likely reverse Trump’s corporate tax cuts, which would hurt all stocks and prompt some liquidation in tech holdings. Chart I-16A Temporary Dollar Bounce Is Likely Chart I-17President Trump"s Disapproval Rating Is A Danger   The tech industry remains an attractive target for populist ire because of its wide profit margins and elevated concentration and market power. During the run-up to November 3rd, investors will be reminded that politicians on both sides of the aisle want to regulate tech. Investors will need to raise the equity risk premium for the sector as these voices get louder. Implications For The Broad Market The strength of the tech sector will be tested in the coming two quarters. Any short-term interruption to the mania prompted by the three aforementioned risks will cause a correction in the S&P 500 because the tech sector (including Google, Amazon, Facebook and Netflix) represents 40% of the index’s market capitalization (Chart I-18). As our equity strategist recently highlighted, without its five largest components (Apple, Microsoft, Amazon, Google and Facebook), the S&P 500 would have increased by only 23% in the past five years instead of its current 54% return. To add color to those numbers, these five tech titans have added $4.8 trillion to the S&P 500 market capitalization versus $3.8 trillion added by the next 495 companies.6   Any short-term interruption to the mania will cause a correction in the S&P 500. Despite this risk, we continue to anticipate that the S&P 500 will find a floor between 2800 and 2900.7 Some crucial factors underpin equities. Global monetary policy remains extraordinarily accommodative, China is stimulating aggressively, Washington will not let a large fiscal cliff destroy the recovery ahead of a presidential election, and the weaker dollar has a reflationary impact on global economic activity. Additionally, we still expect the second wave of COVID-19 to be less deadly than the first and result in much more limited lockdowns compared with March and April. BCA’s neutral stance on tech remains appropriate even after the short-term dynamics discussed above are factored in. The absence of inflationary pressures in the next two years or so and the position of global central banks that they will maintain loose monetary conditions until inflation has overshot a 2% target indicate that conditions persist for an expanding tech mania. Moreover, the dollar’s weakness is unlikely to last more than 12 to 18 months. The US still possesses a higher trend growth rate than the rest of the G-10 and sports a higher neutral rate of interest (Chart I-19). Additionally, China will ultimately rein in its ongoing credit expansion, which will hurt the global industrial cycle. Hence, the deterioration of interest rate differentials between the US and the rest of the world is temporary. Chart I-18The 1% Vs The 99% Chart I-19The US Still Has Stronger Trend Growth   The Return Of The Inflation Trade Chart I-20Will Yields Move Up? To navigate what will remain a trendless but volatile market until the presidential election, we still favor trades levered to the global economic recovery. Inflation breakeven rates can climb further. The inflation trade is back in fashion, with an increase in gold and commodity prices. The weakness in the dollar and the fall in real interest rates are both reflationary, and they will accelerate the uptick in inflation expectations, especially because global central banks have promised to stay behind the inflation curve as the economy recovers. Mounting inflation expectations will also create some near-term upside risks for nominal bond yields. Since the Global Financial Crisis (GFC), an average of the ISM manufacturing survey and its prices paid component have provided useful early signals for yields. This indicator has turned sharply higher (Chart I-20). Moreover, commercial banks are quickly accumulating securities on their balance sheets, which is creating a lot of liquidity. Banks have been able to increase their book value despite generous loan-loss provisions, therefore, they will be able to transform this liquidity into loans when the economic outlook clears enough to ease credit standards. Bond yields will sniff out this situation ahead of time. Central banks want to maintain loose monetary conditions, but there is a limit to how much additional easing they will tolerate as the economy recovers and fiscal support remains generous. Hence, while inflation breakeven rates can move up, the decline in real yields has reached an advanced stage. In this context, if central banks do not provide further accommodation and inflation expectations go up, then real interest rates will cease to decline and nominal rates will start to drift higher. Silver will continue to outperform gold. While we have been positive on gold and gold stocks since June 2019,8 more recently we have strongly favored silver. Industrial uses constitute a larger share of the demand for silver than that of gold. As a result, the silver-to-gold ratio is highly pro-cyclical. While gold is vulnerable to an increased improvement in economic sentiment (Chart I-21), silver will continue to shine in an environment where inflation expectations increase further and economic activity is recovering. We continue to like global deep cyclical equities relative to defensive ones. We continue to like global deep cyclical equities relative to defensive ones. The pickup in China’s economic activity, as captured by our China Economic Diffusion Index, remains consistent with upside to this trade (Chart I-22). Domestic growth will accelerate further in the second half of 2020 because China’s credit flows continue to increase as a share of GDP, especially when companies have yet to spend the funds borrowed in the second quarter. Additionally, infrastructure spending will continue to expand as local governments have only issued 50% of their annual quota of special bonds (Chart I-22, bottom panel). Chart I-21A Risk For Gold Chart I-22China Is On The Go   An outperformance of deep cyclicals relative to defensive equities is also consistent with higher inflation expectations, a rising silver-to-gold ratio and a weaker US dollar (Chart I-23). The near-term outlook also supports buying industrial equities relative to tech stocks. While we have been positive on both materials and industrials, the former has lagged tech. However, our BCA Technical Indicator for US industrial stocks is massively oversold relative to the tech sector (Chart I-24). In light of a declining dollar, rising inflation breakeven rates, strengthening commodity prices and accelerating Chinese credit flows, the probability that industrials outperform tech for three to six months is rapidly escalating. Chart I-23The Inflation Trades Chart I-24Long Industrials / Short Tech   Our relative profits indicator between the industrial and tech sectors is rebounding from depressed readings. The global economic recovery will lift industrials’ revenues more than it will help the tech sector’s income because it will allow weak industrial production levels to improve relative to stable IT spending. Moreover, the industrial wage bill is well contained compared with the tech wage bill. The probability that industrials outperform tech for three to six months is rapidly escalating. Finally, our valuation indicator also favors industrials. Relative to tech stocks, industrial equities are trading at their largest discount since the aftermath of the GFC, suggesting that there is little downside left in this price ratio, at least as long as the dollar is correcting. Mathieu Savary Vice President The Bank Credit Analyst July 30, 2020 Next Report: August 27, 2020   II. Russia And Cyber Security After COVID-19 Dear Clients, This month we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center.  He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy Mathieu Savary Vice President The Bank Credit Analyst As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Chart II-1Russian Cyber Interference Resurfaces Around US Elections As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart II-1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart II-2Russian Excellence In Math Makes It Competitive In Cybernetics Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart II-2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Russia is the source of the most sophisticated cyber threats to the US. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart II-3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart II-3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table II-1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table II-1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks Chart II-4Russian Use Of Cyber Is A Top Threat To The US Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart II-4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. Cyber-crime is rising despite deterrence. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Chart II-5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart II-5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. Chart II-6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart II-6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Chart II-7Cyber Attacks Are On The Rise Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial  proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart II-7). Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. China, Russia, and Iran will also increasingly become victims of cyber attacks. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart II-8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart II-9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart II-8Russia's Relative Weakness Drives Engagement In Cyber Activities Chart II-9Deteriorating Demographics Also Drive Russia’s Cyber Activities   US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map II-1). Map II-1Governments View The Internet As A Frontier To Be Conquered Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart II-10). Chart II-10Countries Have An Imperative To Strengthen Cyber Security We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart II-11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart II-12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. Chart II-11Cyber Security Stocks Have Benefited From COVID-19 ... Chart II-12... But Not So Much Relative To Broad Tech Sector   These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Appendix Table II-1Major Cyber-Attacks Over The Past Decade Works Cited Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan.  “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul.  “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser.  “Competing In The Gray Zone,” RAND Corporation, 2019.  Putin, Vladimir.  “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948). III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but the risk of a tech-led correction has only grown. Moreover, the number of new COVID-19 cases in the US remains elevated and similarly disturbing trends are beginning to take shape in Europe. The recovery could hit a temporary pothole. Finally, as the November election approaches, political and geopolitical risks will come back on investors’ radar screens. Nonetheless, global monetary conditions remain highly accommodative and the risk of inflation in the short-term is minimal. Also, fiscal policy is extremely loose, and despite some procrastination, Congress will pass another large package by August 10, which will protect the economy against a violent relapse. Hence, the worst outcome over the coming three to five months is for the S&P 500 to retest of the 2800-2900 zone. On a cyclical basis, the same indicators that made us willing buyers of stocks since late March remain broadly in place. Stocks are expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator continues to flash a strong buy signal. Tactical indicators suggest that equities must digest the gains made since March 23. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving average are elevated. Additionally, positioning in the derivatives market indicates some degree of vulnerability. Nonetheless, these risks must be put into perspective. Our Composite Sentiment Indicator is not flagging a top in the market and the AAII survey shows a predominance of bears over bulls. As a result, any correction should be limited to 10%. According to our Bond Valuation Index, Treasurys remain extremely expensive. Additionally, our Composite Technical Indicator continues to lose momentum. Guided by the FOMC’s communications, the market has decided that the recovery will lift inflation but that the Fed will stand pat. Consequently, yields are not moving up, but real rates are declining as inflation expectations inch higher. This trend is likely to be at a late stage, and the passage of additional fiscal support as well as a weak dollar will put a floor under real yields. In this context, Treasury yields should begin to rise in the closing months of 2020. The dollar breakdown has now fully taken shape. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. Fiscal deficits remain exceptionally wide and the household savings rate will not remain as elevated as it is today. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. Technically, our Composite Technical Indicator for the dollar has also broken down, which warns that a period of cyclical weakness has begun for the greenback. Nonetheless, our Dollar Capitulation Index is now in oversold territory, and a countertrend bounce is very likely in the coming weeks. Commodities are gaining traction. The Advance / Decline line for the Continuous Commodity Index has broken out to the upside, which suggests that the CCI could punch above its pre-COVID levels by yearend. A weak dollar, low real yields and a global industrial recovery are highly positive for natural resource prices. Within that asset class, gold has made new all-time highs. Gold is especially sensitive to lower real rates and a weak dollar. Sentiment and positioning for the yellow metal are stretched. Any rebound in economic sentiment could push real rates higher, which would cause gold to correct meaningfully in the near future, even if it remains in a cyclical uptrend. A dollar rebound is another tactical risk for gold. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Emerging Markets Strategy Weekly Report "EM Equities: Concentration And Mania Risks," dated July 16, 2020, available at ems.bcaresearch.com 2 Please see US Equity Strategy Special Report "Revisiting Equity Sector Winners And Losers When Inflation Climbs," dated June 1, 2020, available at uses.bcaresearch.com 3 Please see US Equity Strategy Special Report “US Dollar Bear Market: What To Buy & What To Sell," dated June 22, 2020, available at uses.bcaresearch.com 4 Please see The Bank Credit Analyst Monthly Report “January 2020," dated December 20, 2019, available at bca.bcaresearch.com 5 Please see Geopolitical Strategy Special Report "What Is The Risk Of A Contested US Election?," dated July 27, 2020, available at gps.bcaresearch.com 6 Please see US Equity Strategy Insight Report "S&P 5 Versus S&P 495," dated July 23, 2020, available at uses.bcaresearch.com 7 Please see The Bank Credit Analyst Monthly Report "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 8 Please see The Bank Credit Analyst Monthly Report "June 2019," dated May 30, 2019, available at bca.bcaresearch.com

The SPX started the week on the right foot, but we continue to recommend investors avoid chasing equities at this point. Two key risks we have flagged recently are: rising concentration risk of market leaders, and geopolitical-related risks. Today we highlight three additional sources of near-term stress for equity investors. The SPX has failed to outperform gold and a worrisome technical lower high formation has taken root warning of an overall market pullback (top panel). This is eerily similar to the trouble gold sniffed out early in the year, as we highlighted in our mid-January report. The bond market also disagrees with the SPX rally over the past six weeks, as long duration bond prices have been besting the broad equity market since the June 8 peak (middle panel). Tack on the flattening yield curve since then, and a plethora of warning signs reiterate our near-term cautious view (bottom panel). Bottom Line: While our cyclically sanguine broad equity market view remains intact, we are cautious on the short-term prospects of the S&P 500.  

Highlights US Dollar: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Currency-Hedged Bond Yields: For USD-based investors, US Treasuries still offer enough yield such that currency-hedged non-US government bond yields remain less appealing in most countries. The notable exceptions are Germany, France, the UK, Sweden and Japan, where both unhedged and USD-hedged yields are below comparable US yields – stay underweight those sovereign markets versus the US in USD-hedged portfolios. Currency-Hedged Corporates: For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios. Feature Chart of the WeekStart Hedging USD Exposure? The mighty US dollar (USD), which had remained impervious to plunging US interest rates and surging US COVID-19 cases, is finally breaking down. The DXY index of major developed economy currencies is down -3% so far in 2020, and nearly -10% from the peak seen in March during the worst of the COVID-19 global market rout. Other forms of currency, like precious metals and even Bitcoin, are also surging with the price of gold hitting a new all-time high yesterday. A new USD bear market would represent a major change to the global economic and investment landscape, affecting global economic growth, inflation, corporate profitability and capital flows. We will cover these topics in more detail in the coming weeks and months with the USD entering what appears to be a sustainable bearish trend. In this report, however, we tackle the most basic question for global fixed income investors in light of the new weakening trend for the USD – what to do with non-US bond holdings, and currency hedges, after nearly a decade of generating outperformance by hedging non-US currencies into USD (Chart of the Week). Say Farewell To The USD Bull Market Chart 2These Currencies Have Clearly Broken Out The latest breakdown of the USD has been broad-based across the developed market currencies, although some currencies have been faring much better. The biggest moves versus the USD have been for majors like the euro, Australian dollar and Swiss franc, all of which have clearly broken out above their 200-day moving averages (Chart 2). In fact, the 200-day moving averages for those currencies are now moving higher, indicating that the new medium-term trend for those pairs is appreciation versus the USD. Other important currencies like the British pound, Canadian dollar and Japanese yen have gained ground versus the USD, but at a much slower pace (Chart 3). This reflects some of the unique issues within those economies (ongoing Brexit uncertainty in the UK, the pause in the oil price rally in Canada and flailing growth in Japan). Yet even the Chinese yuan, heavily managed by Chinese policymakers, has seen some mild upward pressure versus the greenback (bottom panel). The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. There are numerous reasons why this is happening now and is likely to continue doing so in the months ahead: The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. The Fed’s aggressive rate cuts earlier this year – and even dating back to the 75bps of easing delivered in 2019 – have dramatically reduced the robust interest rate differentials that had previously boosted the USD and attracted global capital flows into the currency (Chart 4). This is true for both nominal and inflation-adjusted real yields. Chart 3These Currencies Are On The Cusp Of Breaking Out Chart 4Low US Rates + Better Non-US Growth = A Weaker USD Chart 5Does The USD Require A COVID-19 Risk Premium? Chart 6Relative QE Trends Are USD-Negative Chart 7The USD Is No Longer A High Carry Currency Economic growth has been rebounding from the COVID-19 shock faster outside the US. The latest round of manufacturing purchasing managers’ index (PMI) data for July published last week showed significant monthly increases in the euro area, the UK and even Japan, with only a modest pickup in the US. This boosted the spread between the US and non-US manufacturing PMI, which correlates strongly to the price momentum of the US dollar, to the highest level in nearly three years (bottom panel). The surge in new COVID-19 cases in the southern US states represents a dramatic divergence with the lower number of cases in Europe and other developed countries (Chart 5). While there are some renewed flare-ups of the virus in places like Spain and Japan, the numbers pale in comparison to the explosion of new US cases. With the most affected areas in the US already reestablishing restrictions on economic activity, the gap between US and non-US growth seen in the PMI data is likely to widen in a USD-bearish direction. The Fed has been more aggressive in the expansion of its balance sheet compared to other major central banks like the ECB and Bank of Japan. While not a perfect indicator, the ratio of the Fed’s balance sheet to that of other central banks did coincide with the broad directional moves in the USD during the Fed’s “QE-era” after the 2008 financial crisis (Chart 6). We may be entering another such period, but with a lower impact as many other central banks are also aggressively expanding their balance sheets through asset purchases. Summing it all up, it is clear that the US weakness has further to run over the next few months - and perhaps longer with the Fed promising the keep the funds rate near 0% until the end of 2022. This fundamentally alters bond investing, and currency hedging, considerations, as the carry earned by being long US dollars is now far less attractive than has been the case over the past few years (Chart 7). In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. Bottom Line: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Where Are The Most Attractive Yields Now For USD-Based Investors? Chart 8Puny Bond Yields Across The Developed Markets In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. That makes the decisions on bond allocation at the country level more challenging, as the relative yields on offer represent a tiny proportion of a bond’s overall return on a currency-unhedged basis. For example, a 30-year US Treasury currently yields 1.25%, while a 30-year German government bond yields -0.08% (Chart 8). While the decision to hold the US Treasury over the German bond should be obvious given that 133bp (annualized) yield differential, the -4.6% decline in EUR/USD seen so far in the month of July alone has already swamped the additional income earned by owning the US Treasury. This example shows why the decision to actively take, or hedge, the currency exposure of a foreign bond relative to a domestic equivalent so important for any global fixed income investor. For someone whose base currency is entering a depreciation trend, like the USD, the currency decision becomes critical – in fact, it is the ONLY decision that matters for the expected return on any unhedged bond allocation. A proper “apples for apples” comparison of the relative attractiveness of yields in different countries, however, needs to be done after adjusting for cost of currency hedging. On that basis, US fixed income assets still look relatively attractive, even in a USD bear market. In Tables 1-4, we present developed market government bond yields across different maturity points (2-year, 5-year, 10-year and 30-year) for twelve countries. In each table, we show the current yield in local currency terms, while also showing the yield hedged into six different currencies (USD, EUR, GBP, JPY, CAD, AUD). We calculate the gain/cost of hedging using the ratio of current spot exchange rates and 3-month forward exchange rates. That is an all-in cost of hedging that includes both short-term interest rate differentials and the additional currency funding costs determined by cross-currency basis swaps. Table 1Currency-Hedged 2-Year Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields Using the example of the 30-year US and German bonds described earlier, that 30-year German yield of -0.08%, hedged into USD, has an all-in yield of +0.74%. This is still well below the 30-year US Treasury yield of 1.25%. Thus, that 30-year EUR-denominated German bond is unattractive compared to the USD-denominated US Treasury, after converting the German bond to a USD-equivalent security through hedging. That relationship holds even if we were to hedge the Treasury into euros. As can be seen in Table 4, the 30-year US Treasury has a EUR-hedged yield of +0.48%, 56bps above the EUR-denominated 30-year German bond yield. Therefore, while owning the US Treasury seems like the riskier bet on an unhedged basis now with the EUR/USD appreciating rapidly, the US bond is the superior yielding bet once currency risk is hedged away. Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities. For those that prefer charts over numbers, much of the data in Tables 1-4 is shown as static snapshots of government bond yields curves in Chart 9 (for local currency, or unhedged, yield curves), while Chart 10 shows all yields hedged into USD. The charts show that there appear to be far more interesting relative value opportunities across countries at varying yield maturities now, but those gaps become smaller after hedging non-US bonds into USD. Chart 9Currency-Unhedged Global Government Bond Yield Curves Chart 10USD-Hedged Global Government Bond Yield Curves Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities, making those bonds interesting to USD-based investors that choose to either take or hedge the EUR and AUD exposure of those bonds. In Tables 5-8, we take the yield data from the previous tables and show the hedged yields as spreads to the “base yield” of each currency, which is the government bond yield for that country. For example, in Table 3, we can see that for all countries shown, the 10-year yield hedged into GBP terms produces a yield that is above that of the 10-year UK Gilt. This is true even or negative yielding German bunds and Japanese government bonds. Thus, looking purely from a yield perspective, currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Table 5Currency-Hedged 2-Year Govt. Bond Yields Spreads Within The "G-6" Table 6Currency-Hedged 5-Year Govt. Bond Yields Spreads Within The "G-6" Table 7Currency-Hedged 10-Year Govt. Bond Yields Spreads Within The "G-6" Table 8Currency-Hedged 30-Year Govt. Bond Yields Spreads Within The "G-6" Chart 11Global Spread Product Yields Are Low We can try the same analysis above for global spread products like corporate debt. Currency returns still matter for the returns on these assets, but less so given the higher outright yields offered compared to government bonds. Yields are relatively low across investment grade credit, junk bonds, mortgage-backed securities and emerging market debt after the massive rallies seen since March, but remain much higher than the sub-1% levels seen in most of the developed market government bond universe (Chart 11). In Table 9, we show the index yield (using Bloomberg Barclays indices) in both unhedged and currency-hedged terms for the main global credit sectors we include in our model bond portfolio universe. The index yields do not change that much after currency hedging costs are included, but there are some notable differences between corporate bonds of similar credit quality in the US and euro area. Table 9Currency-Hedged Spread Product Yields Specifically, for both investment grade and high-yield corporate credit, the yield in the US is higher than that seen in the euro area. This is true for both USD-hedged and EUR-hedged terms, thus making US corporates more attractive simply from a yield perspective without factoring in credit quality. Currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Looking within the high-yield universe by credit tiers, US yields are higher than euro area equivalents for Ba-rated bonds, while euro area yields are slightly higher for B-rated debt (Chart 12). Yields on lower-quality Caa-rated debt are similar, both for US yields hedged into euros and vice versa. Chart 12No Major Differences In US & Euro Area Junk Yields Within investment grade, there is no contest with US yields higher than euro area equivalents across all credit tiers (Chart 13). Chart 13US IG Yields Are More Attractive Than Euro Area IG (in USD & EUR) Summing it all up, the new trend towards USD weakness has not altered much of the relative attractiveness of US fixed income assets on a currency-hedged basis for USD-based investors. This is true even after the sharp fall in US bond yields since March. Bottom Line: In Germany, France, the UK, Sweden and Japan, both unhedged and USD-hedged government bond yields are below comparable US Treasury yields – underweight those sovereign markets versus the US in USD-hedged portfolios. For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights We reiterate our longstanding overweight on healthcare equities for the next 12 months and possibly beyond. The macro environment, as well as underlying demand factors, will continue to drive the sector’s outperformance. Within healthcare equities, we favor biotechnology and healthcare technology over pharmaceuticals. Healthcare corporate bonds, however, are not especially attractive, and therefore warrant no more than a neutral position. Feature Chart 1Healthcare Has Outperformed Over The Past Decade... Over the past decade, global health care stocks have been clear outperformers, alongside information technology and consumer discretionary stocks, rising by almost 50% relative to the broad market (Chart 1). Not only have they benefited from increased demand from an aging population in developed economies and a growing middle class in emerging markets, they have also provided a downside cushion during recessions and bear markets, given their defensive, non- cyclical nature. The COVID-19 pandemic leads us to reiterate our longstanding overweight position on global healthcare equities over the next 12 months and possibly beyond. Favorable tailwinds will continue to drive healthcare outperformance. It is likely that government spending on healthcare will increase over the coming years. Innovative solutions in healthcare technology (healthtech), as well as increased overall research and development (R&D), the shift to value-based healthcare delivery, the focus on preventive medicine, and a low risk of substantial regulatory change and reform (at least in the US, assuming former Vice President Biden is elected president this November) should continue to support the sector’s outperformance. In this Special Report, we analyze whether our long-term overweight position on healthcare equities remains valid. In a later section, we also review healthcare-related investments in bonds and private equity. Why We Like Healthcare BCA Research’s Global Asset Allocation (GAA) service has been positive on global healthcare stocks for over five years. The main reason is that we see demand for healthcare services continuing to rise, as life expectancy increases, populations age – people over 65 will comprise 25% of the developed world’s population by 2040, up from 15% in 2020 – and the middle class in emerging economies becomes richer (Charts 2&3). As people live longer, healthcare spending should rise since, after the age of 65 (retirement), it tends to squeeze out discretionary spending (Chart 4). Chart 2...As The Global Population Grew Older... Chart 3...And Richer       Healthcare spending everywhere represents a large proportion of GDP, but the percentage varies considerably between countries. In the US for example, healthcare spending comprises 16.9% of GDP, higher than in other advanced economies, where it averages 9.9%, and substantially higher than in emerging economies (average 6.5% of GDP) (Chart 5). It is likely that these figures will increase over the next few years. Chart 4Healthcare Expenditure Dominates Late-Life Spending Chart 5Spending On Healthcare Will Rise   A strong case can be made for serious outbreaks of infectious diseases becoming more common, and therefore governments will have to increase their readiness. The number of countries experiencing a significant outbreak has almost doubled over the past decade, after being on a declining trend during the prior 15 years (Chart 6). The World Health Organization (WHO) warns that, while pandemics are rare, highly disruptive regional and local outbreaks are becoming more frequent and causing more economic damage.1 The non-cyclical nature of healthcare demand makes the industry less vulnerable to economic downturns. In times of below-trend growth, investors rush into defensive-growth stocks. Over the past two recessions, the drawdown of healthcare equities was, respectively, 20% and 27% less than the broad market. Chart 6Number Of Countries Experiencing Serious Outbreak Of Infectious Disease Chart 7The Defensive Side Of Healthcare   However, the sector is not totally cyclically insensitive, given its capital intensity and reliance on debt. In the US, healthcare sector debt amounts to almost $500 billion (Chart 7). This also leaves it vulnerable to rising interest rates. Nevertheless, the current macro outlook should keep a lid on interest rates for some time. The healthcare industry has lagged in digitalization (Chart 8). This offers wide-ranging opportunities for the sector, particularly in healthtech, biotechnology, and pharmaceuticals. Innovative solutions in robotics, artificial intelligence (AI), and genomics will drive the industry in the years to come. Digitalization will accelerate productivity and improve profitability. Chart 8The Healthcare Sector Is Way Behind In Digitalization Lastly, valuations for healthcare equities in most countries remain attractive, close to their long-run averages. The only exceptions are the UK and Japan, which are two standard deviations above the historical mean relative to their respective markets (Chart 9). The Future Of Healthcare Every crisis provides insights into what went wrong, what needs to be changed, and what areas should be explored. The COVID-19 pandemic is no exception. The pandemic has highlighted supply-chain fragilities, particularly a shortage of some healthcare equipment and drugs, the production of which is outsourced. In the US, for example, according to the Food and Drug Administration (FDA), over 70% of facilities producing essential medicines for the US are located abroad (Chart 10). Chart 9Valuations Remain Reasonable Chart 10Supply Chain Fragilities   Some argue that reshoring healthcare production is essential. Joe Biden, favored to be the next US president, has highlighted this in his plan to rebuild US supply chains.2 This could, however, lead to higher healthcare costs. This would either require increased government spending to subsidize medical expenses, or lead to fewer people being able to afford adequate healthcare. This effect would be pronounced in economies where a large percentage of the population is uninsured, around 10% in the US, and much more so in some emerging economies where healthcare quality is poor. This might be less of a risk for pharmaceutical and biotechnology companies, where the largest cost of bringing a new drug to market is R&D and marketing, rather than manufacturing. In the first months of the outbreak, resources such as ventilators, hospital and ICU beds, and basic personal protective equipment (PPE) quickly became scarce. Inventories of such items and overall hospital capacity will need to increase. This will entail massive investments to boost the public healthcare infrastructure and increase the number of healthcare workers. Chart 11COVID-19 Unveiled Poor Health Standards... The pandemic also underlined weaknesses in social and health standards. The excessive number of deaths from COVID-19 in nursing homes in some developed economies emphasizes the need for investment in this area. For example in Quebec, Canada, a staggering 80% of the province’s deaths occurred in nursing homes and senior residences (both public and private), illustrating the mismanagement and lack of funding (Chart 11). Most notably, care homes run for profit (approximately 70% of the total in the US) have seen almost four times as many COVID-19 infections as those not. The quality ratings of for-profit nursing homes, as measured by the Centers for Medicare and Medicaid Services (CMS), are much lower on average than those of non-profit or government-run facilities (Chart 12). This could imply the mass nationalization of nursing homes. However, this is unlikely. A better option would be to impose higher standards on privately run homes, reducing the sector to a smaller number of high-quality providers. Chart 12...In Most For-Profit Nursing Homes Chart 13The Evolution Of Genome Sequencing Is Illustrated In The Price More positively, there remains a large gap to be filled by a new era of technology-driven, integrated, and online healthcare. Investments in biotechnology – particularly related to genetic information – are also likely to increase, as DNA sequencing becomes cheaper (Chart 13). The way patients interact with physicians will also change. The American Medical Association (AMA) surveyed more than 1000 physicians on the use of digital tools in their practices. Reliance on digital tools for monitoring and clinical support has increased significantly over the past three years. The largest jump however was in the number of practices using telemedicine and virtual visits (Chart 14). Chart 14The Transition To A Digital-Driven Healthcare Model “Contact tracing” is a term that has been widely used during the coronavirus outbreak. The ability to track those infected and monitor their interactions to limit the spread of the virus is seen as a crucial step to mitigate further contagion. This would help not only to eradicate the virus, but might be developed into a long-lasting technology. Similar to how security screening equipment was developed after 9/11, there should be investment opportunities in the medical-screening segment. Breaking Down Healthcare Equities It is important to note that not all healthcare equities are equal: Different regions and industries have performed differently. In this report, we distinguish between the industry groups and subgroups, based on the GICS Level 2 and Level 3 classifications. We also look at the nine largest regions in the MSCI indexes to see if certain regions provide more favorable opportunities. Healthcare equities are broken down into two industry groups, which in turn break down into six industries: Healthcare equipment & services Healthcare equipment & supplies Healthcare providers & services Healthcare technology Pharmaceuticals, biotechnology & life sciences Pharmaceuticals Biotechnology Life sciences tools & services In Table 1, we drill down the constituent weights of the MSCI healthcare indexes. This allows us not only to analyze the size of the sector and its parts, but also to gain multiple insights. For example, a bet on Swiss healthcare stocks is essentially a bet on pharmaceuticals, given the greater-than-80% weighting of that industry. Exposure to the overall Danish equity index is by default a play on healthcare stocks, since they comprise almost 60% of the index. Table 1Global Healthcare Weights Chart 15Healthcare Has Outperformed Broad Indices Globally... As noted earlier, global healthcare stocks have outperformed the broad index by almost 50% over the past decade. This is true across all regions. However, several distinctions can be made. US, Swiss, and Danish healthcare equities have outperformed the global healthcare benchmark over the past decade, but their counterparts in the euro area, UK, and Japan have lagged (Chart 15). On a risk-adjusted basis, Danish healthcare equities have been the best performer with a Sharpe-ratio of 0.84 and an annualized return of 18% since 2000 (Table 2).   Table 2...However Not All Healthcare Stocks Are Alike Investment Opportunities Chart 16Within Healthcare Equities, Favor Biotechnology and Healthcare Technology... Viewing healthcare as a set of separate segments, rather than as a single industry, highlights pockets of opportunity.  A selective approach might be preferable for asset allocators in the coming years. As discussed in The Future Of Healthcare section, the sector is likely to shift to a model that relies more on technology, is data-driven, and harnesses the power of digitization, robotics, and AI. The patient will be at the center of the new healthcare model.  We divide our overview of investment opportunities into three categories: equities, corporate bonds, and private investments. Equities: Based on our view of the future of healthcare and the structure of the GICS equity classifications, we favor biotechnology and healthcare technology, and would have only a benchmark allocation to pharmaceuticals. There are insights to be drawn from the fundamentals, historical performance, and valuation metrics. Historically, pharmaceutical equities stand out as the worst performers within the sector. Over the past decade, they have underperformed the global healthcare benchmark by 20%, whereas biotechnology and healthcare technology stocks have outperformed by 59% and 127%, respectively (Chart 16). The outperformance of biotechnology has predominantly been earnings-driven, whereas pharmaceuticals’ and healthcare technology stock prices appear to be detached from earnings (Chart 17). It is worth nothing that despite the fact that valuations for those industries appear expensive relative to the broad market, we remain positive on their outlook. As we drill deeper into Level 3 industries, the small number of constituents within the index makes relying on valuations challenging (Chart 18). Chart 17..Despite A Detachment From Earnings... Chart 18...And Elevated Valuations   Chart 19No Attractive Opportunities Within Healthcare Corporate Bonds Corporate Bonds: Within the corporate bond universe, we favor those that qualify for central banks’ purchase programs: Investment-grade bonds and the highest tranche of high-yield. BCA Research’s US fixed-income strategists have an overweight recommendation on US healthcare corporate bonds, though their recommendations are based on a six-to-12 month investment horizon rather than the longer perspective that we are taking in this report.3 Both healthcare and pharmaceuticals bonds, similar to their equity counterparts, trade defensively, outperforming the broad corporate index when spreads widen and underperforming as they tighten (Chart 19). This applies to both investment-grade and high-yield bonds. The credit risk measure favored by our US bond strategists is the duration-times-spread (DTS) ratio. This measure confirms the sector’s defensive nature: A value below 1 implies credit risk lower than the market. However, the recent uptick in the DTS ratio of healthcare investment-grade bonds shows the sector has become riskier and as such may trade more cyclically in the short term. Nevertheless, the macro environment should remain favorable. Pricing power is still strong, with medical care services rising by almost 6.0%, and drug prices rising by 1.4% on a year-over-year basis, outpacing overall consumer prices (Chart 20). Neither segment within the investment-grade space offers an attractive spread advantage over the broad index. However, the risk outlook for healthcare remains better than that for pharmaceuticals, particularly related to political risk (as discussed later in the Risks section). Private Investments: Venture-capital investments in healthtech reached a quarterly record high of $8.2 billion in Q1 2020. The recent pandemic is likely only to push this trend higher. Moreover, large private-equity investments in recent years have been targeted at biopharma.4 According to Bain & Company, global biopharma private-equity deals where value was disclosed, reached $40.7 billion in 2019, up from $16.5 billion the prior year.5  The number of biotech firms going public is also trending up, despite slipping to 48 in 2019 from 58 in 2018 (Chart 21). To date (as of early June), 21 out of 43 US IPOs this year are healthcare-related. Chart 20Pricing Power Remains Favorable Chart 21More Biotech IPOs Are Coming To Market   Additionally, M&A activity has been increasing, particularly within the biotechnology segment, although the economic shutdown has slowed the deal flow recently. The number of M&A deals peaked in March 2020, when the average premium is 45% (Chart 22). The long-term rising trend is likely to persist. Over the next year, firms with drugs or vaccines related to COVID-19 would be clear targets for acquisitions and should outperform. Over the long term, we also expect to see some industry consolidation. Risks We see the following as the biggest risks to our overall positive outlook for healthcare investments: Quicker-Than-Expected Economic Growth Rebound: As we highlighted, the healthcare sector is defensive – outperforming the broad market during recessions and economic slowdowns. However, if growth rebounds more quickly, driven by further fiscal and monetary stimulus, the upside for healthcare performance could be challenged. Political Risk: Joe Biden might swing to the left in the run-up to the US presidential election to bring on board supporters of Elizabeth Warren and Bernie Sanders. Nevertheless, we see that particular risk for healthcare as relatively small (Chart 23). Biden’s approach is to restore and expand Obamacare (the Affordable Care Act, or ACA), shifting some of the burden of healthcare spending from individuals to the government. Overall, this should be positive for healthcare spending, particularly for insurers and healthcare providers. However, pharmaceutical companies may face headwinds if the administration imposes price caps on drug prices. Chart 22Secondary Market Activity Is Also Strong Chart 23Political Risk Has Waned As Biden's Chances Of Election Have Increased Chart 24Reliance On Inorganic Growth Might Prove Unsustainable Lack Of Innovation: Over the past two decades, the healthcare sector has shifted to relying on inorganic growth, driven by takeovers, rather than on research and development. Capital expenditure as a percentage of sales by both pharmaceutical and biotechnology firms fell sharply in the 2000s and has stagnated around 2% and 4%, respectively since (Chart 24). Only A Few Make It: While more IPOs in the healthcare sector is a sign of improving innovation, it is worth noting that only a few newly listed companies are successful. Over the past decade, only 3% of the 349 biotech IPOs had positive earnings at the time of their IPO. This nevertheless is a consequence of the nature of the industry: Companies tend to list while they await a big breakthrough in product development or regulatory approval. Conclusion We continue to recommend investors hold an above-benchmark allocation to healthcare-related investments on a long-term basis. Aging populations, the need to improve the quality of global healthcare, a likely increase in government spending, the shift to digitalized healthcare, and demand which is non-cyclical all support this stance. Healthcare equities in general, and particularly biotechnology and healthcare technology, should perform well over the coming years. For investors with global mandates, allocations to US, Swiss, and Danish healthcare equities should outperform those in the euro area, Japan, and the UK. Corporate bonds do not offer any advantage over the broad corporate US bond index. Political risks for the US healthcare sector should be limited even if the Democrats win the White House. However, the risk is highest for pharmaceuticals, in the event where the government imposes price caps.   Amr Hanafy Senior Analyst amrh@bcaresearch.com   Footnotes 1  "World Economic Forum, Outbreak Readiness and Business Impact, Protecting Lives and Livelihoods across the Global Economy," January 2019. 2  For more info please see Joe Biden https://joebiden.com/supplychains/ 3  Please see US Bond Strategy, "Assessing Healthcare & Pharma Bonds In A Pandemic," dated June 9, 2020.available at usbs.bcaresarch.com. 4  Biotech refers to manufactured products that rely on using living systems and organisms. The biopharma industry is backed by biotechnology, the science, which allows products to be manufactured biologically. 5  Bain & Company, Global Healthcare Private Equity and Corporate M&A Report 2020.

Last Friday, my colleague Dhaval Joshi and I held a webcast discussing investment strategies. The topics of discussion included global equity valuations, mega-cap stocks leadership and the outlook for EM stocks, fixed-income and currencies. You can listen to the webcast recording by clicking here.   An Opportunity In Pakistani Equities And Bonds Pakistani stock prices in US dollar terms are currently 20% lower than their January high and 56% lower than their 2017 high (Chart I-1, top panel). Meanwhile, the government projected a contraction in real GDP during the fiscal year 2019-20 (ending on June 30), the first in 68 years. We believe stock prices have already priced in plenty of negatives, and that Pakistani equities are likely to move higher over the next six months. Strengthening the balance of payments (BoP) position and continuing policy rate cuts will increase investors’ confidence and benefit its stock market (Chart I-2). We also expect the Pakistani bourse to outperform the EM equity benchmark (Chart I-1, bottom panel). Chart I-1Pakistani Equities: More Upside Ahead Chart I-2Monetary Easing Will Help Pakistani Equities   Chart I-3The Current Account Deficit Is Set To Shrink Further Balance Of Payments Position Pakistan’s BoP position is set to improve. First, its trade deficit will shrink further, as Pakistan’s export will likely improve more than its imports (Chart I-3). The country’s total exports declined 6.8% year-on-year in June, which is a considerable improvement as compared to the massive 54% and 33% contractions that occurred in April and May, respectively. The country was on a strict lockdown for the whole month of April, which was then lifted in early May. As the number of daily new cases and deaths are falling, the country is likely to remain open, lowering the odds of a domestic supply disruption. In addition, as DM growth recovers, the demand for Pakistani products will improve as well. Europe and the US together account for about 54% of Pakistan’s exports. The government is keen to boost the performance of the domestic textile sector, which accounts for nearly 60% of the country’s total exports. The government will likely approve the industry’s request for supportive measures, including access to competitively priced energy, a lower sales tax rate, quick refunds, and a reduction of the turnover tax rate. Moreover, the government has prepared an incentive package for the global promotion of the country’s information technology (IT) sector, aiming to increase IT service exports from the current level of US$1 billion to US$10 billion by 2023. Currently, over 6,000 Pakistan-based IT companies are providing IT products and services to entities in over 100 countries worldwide. Regarding Pakistan’s imports, low oil prices will help reduce the country’s import bill year-on-year over the next six months. Second, remittance inflows – currently at 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. Even though about half of the remittances sent to Pakistan are from oil-producing regions like Saudi Arabia, UAE, Oman and Qatar, low oil prices may only have a limited impact on Pakistan’s remittance inflows. For example, when Brent oil prices fell to US$40 in early 2016, remittances sent to Pakistan in the second half of that year declined by only 1.9% on year-on-year terms. Over the first six months of this year, the remittances received by Pakistan still had a year-on-year growth of 8.7%.   At the same time, the government has planned various measures to boost remittances. For example, a “national remittance loyalty program” will be launched on September 1, 2020, in which various incentives would be given to remitters. Strengthening the balance of payments (BoP) position and continuing policy rate cuts will increase investors’ confidence and benefit its stock market. Third, Pakistan will receive considerable financial inflows this year, probably amounting to over US$12 billion1 from multilateral and bilateral sources. This will be more than enough to finance its current account deficit, which was at US$11 billion over the past 12 months. In April, the International Monetary Fund (IMF) approved the disbursement of about US$1.4 billion to Pakistan under the Rapid Financing Instrument designed to address the economic impact of the Covid-19 shock. The World Bank and the Asian Development Bank have also pledged around US$ 2.5 billion in assistance. The IMF and the Pakistani government are in talks about the completion of the second review for the Extended Fund Facility (EFF) program. If completed in the coming months, the IMF will likely disburse about US$1 billion to Pakistan in the second half of this year.  In April, G20 countries also awarded Pakistan a suspension of debt service payments, valued at US$ 1.8 billion, which will be used to pay for Pakistan’s welfare programs. In early July, the State Bank of Pakistan (SBP) received a US$1 billion loan disbursement from China. This came after Beijing awarded Pakistan a US$300 million loan last month. The authorities plan to raise US$1.5 billion through the issuance of Eurobonds over the next 12 months. Other than the funds borrowed by the Pakistani government, net foreign direct inflows, mainly driven by phase II of the China-Pakistan Economic Corridor (CPEC), are set to continue to increase over the remainder of this year, having already grown 40% year-on-year during the first six months of this year. About 63% of that increase came from China. Meanwhile, as we expect macro dynamics to improve in the next six months, net portfolio investment is also likely to increase after having been record low this year (Chart I-4). In addition, as the geopolitical confrontation between the US and China is likely to persist over many years, both Chinese and global manufacturers may move their factories from China to Pakistan.2 Bottom Line: Pakistan’s BoP position will be ameliorating in the months to come. Lower Inflation And Monetary Easing Continuous monetary easing is very likely and will depend on the extent of the decline in domestic inflation. Both headline and core inflation rates seem to have peaked in January (Chart I-5). Significant local currency depreciation last year had spurred inflation in Pakistan. Then, early this year, supply disruptions and hoarding behaviors attributed to the pandemic have contributed to elevated inflation. Chart I-4Net Portfolio Investment Inflows Are Likely To Increase Chart I-5Both Headline And Core Inflation Rates Will Likely Fall Further   A closer look at the inflation subcomponents shows that recreation and culture, communication, and education have already fallen well below 5% in the last month. Transport inflation came in negative at 4.4% in June.  The inflation of non-perishable food items was still stubbornly high at 14.9% last month. Increasing the food supply and reducing hoarding will help ease that. This, along with a stable exchange rate and a negative output gap will cause a meaningful drop in inflation. As inflation drops, interest rates will be reduced to facilitate an economic recovery. While the current 7% policy rate is lower than headline inflation, and on par with core inflation, Pakistani interest rates remain much higher than those in many other emerging countries. Investment Recommendations We recommend buying Pakistani equities in absolute terms and continuing to overweight this bourse within the emerging markets space. The stock market will benefit from a business cycle recovery following the worst recession in history, worse than during the 2008 Great Recession (Chart I-6). Fertilizer and cement producers, which together account for nearly 30% of the overall stock market, will benefit from falling energy prices, a significant cut in interest rates and supportive government measures. The government recently approved subsidies to encourage fertilizer output. In the meantime, the country’s construction stimulus package and its easing of lockdown orders will help lift demand for cement over the second half of 2020.  As a result, both fertilizer and cement output are set to increase (Chart I-7). Besides, a cheapened currency will limit fertilizer imports and help cement producers export their output, which will benefit their revenue. Chart I-6Manufacturing Activity In Pakistan Will Soon Rebound Chart I-7Both Fertilizer And Cement Output Are Set To Increase   Banks account for about 22% of the overall stock market. Our stress test on the Pakistani banking sector shows it is modestly undervalued at present (Table I-1). Even assuming the worst-case scenario for non-performing loans (NPL), where the NPL ratio would rise to 17.5% from the current 6.6%, the resulting adjusted price-to-book ratio will be only 1.6. Table I-1Stress Test On Pakistani Banking Sector Both in absolute terms, and relative to EM valuations, Pakistani stocks appear attractive (Charts I-8 and I-9). Finally, foreign investors have bailed out of Pakistani stocks and local currency bonds since 2018, as illustrated in Chart I-4 on page 4. Ameliorating economic conditions will lure foreign investors back. Chart I-8Pakistani Equities: Valuation Measures Are Attractive In Both Absolute Terms… Chart I-9…And Relative To The EM Benchmark   For fixed-income investors, we recommend continuing to hold the long Pakistani local currency 5-year government bonds position, which has produced a 12% return since our recommendation on December 5th 2019. We expect interest rates to drop another 100 basis points (Chart I-5, bottom panel, on page 5).  Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Chile: Not Out Of The Woods Copper prices have staged an impressive rally in the past four months, but the performance of Chilean markets remains lackluster (Chart II-1). While the red metal has broken above its January highs, Chile’s equities and currency are still trading 25% and 5% below their January peak, respectively.    The government’s mismanagement of the pandemic has reignited and heightened the existing socio-political discontent, thus increasing the fragility of the situation. We therefore recommend that investors maintain a cautious stance on Chilean assets. As for dedicated EM portfolios, we recommend moving this bourse from neutral to underweight: First, the lockdowns resulting from the pandemic have revealed the precarious financial condition of low and middle-class households. The lack of savings among these groups prevented workers from self-isolating for more than a couple of weeks. The urge for them to return to work enabled the outbreak to escalate in May. Consequently, these social groups have suffered from infections, and Chile has rapidly become one of the worst affected countries in the world in terms of per-capita COVID-19 cases and deaths. Chart II-2 shows that, as a share of total population, Chile tops the region in terms of cummulative cases and deaths. Moreover, Chile has the eighth highest COVID-19 infections per capita in the world, even though its testing rate per capita is lower than that of Europe and the US. Chart II-1Chilean Markets Have Been Much Weaker Than Copper Chart II-2The Pandemic Has Hit Chile Hard   Chart II-3The Economy Is In The Doldrums Given the wide spread of the virus, Chile has implemented harsher quarantine measures than the rest of the region, which means that the economic reopening and recovery will start from a lower level of activity. The inability of President Pinera’s administration to protect low and middle-class households from being exposed to the virus has renewed a nation-wide distrust in the government. According to Cadem, one of the country’s most cited polling companies, President Pinera’s approval rating has fallen back to just 17%, not far from the lows seen during last year’s violent social unrest. In sum, these recent events have confirmed our major theme for Chile, discussed in our December Special Report. It reads as follows: Chile’s political elite has been greatly underestimating the depth and gravity of the popular frustration and has been reluctant to address the issue in a meaningful way. Consequently, Chile is set to experience a renewal in protests and a rise in political volatility as the date of the referendum on the Constitution, which is scheduled to take place in October, nears. Second, Chile is experiencing its worst recession in modern history. Chart II-3shows that the economy was already in a slump at the beginning of the year, and the economic lockdown has caused double-digit contractions in many sectors. Further, business confidence never fully recovered from last year’s social protests and has been plummeting deeper since the start of the pandemic (Chart II-3, bottom panel). Chart II-4Banks' NPLs Are Set To Rise While President Pinera’s decision to prioritize small and medium-sized businesses (SMEs) has been popular among the middle class, the reality is that Chile remains a highly oligopolistic market, dominated by large companies. The failure to support these businesses will prevent a revival in business sentiment, hiring and investment and, hence, prolong the economic downtrend. This unprecedent economic contraction has caused a rapid surge in non-performing loans (NPLs), which will hurt banks’ capital profits and tighten lending standards. NPLs will rise much further given the record depth of this recession (Chart II-4). Moreover, bank stocks compose 25% of the MSCI Chile index, so a hit to banking profitability will exert downward pressure on the equity index. Third, even though fiscal and monetary stimuli have been large and were implemented rapidly, they are probably insufficient to produce a quick recovery. The government first announced a fiscal plan between March 19 and April 8 worth US$ 17 billion (or 6% of GDP), the third largest in the region. However, it is still quite small compared to that of OECD members. Excluding liquidity provisions for SMEs and tax reductions, the size of new government spending in 2020 is only 3.5% of GDP. On June 14, the government devised another fiscal plan, worth US$ 12 billon (or 5% of GDP). However, it will be spread out over the next 24 months – only 1.5% of GDP of additional stimulus will be injected over the next 12 months. This extra kick in spending seems too small given the depth of the recession.  In terms of monetary policy, the Chilean central bank has already reached the limits of its orthodox toolkit. The monetary authorities have cut the policy rate by 125 basis points since November of last year, but they have reached the constitutional technical minimum of 0.5%. The central bank is now using alternative tools to stimulate the economy, such as offering cheap lending to SMEs and a US$ 8 billion quantitative easing program for buying financial institutions’ bonds, as the Constitution forbids the purchasing of government and non-financial corporate debt. In a nutshell, the overall efficiency of these monetary policies will be subdued as the main drags on the economy are downbeat business and consumer confidence stemming from ongoing socio-political tensions, not high interest rates. Chile is shrouded in a cloud of political uncertainty. Monetary policy has reached its limits, and fiscal stimulus is insufficient for now. Fourth, higher copper prices will help on the margin, but will not bail out the Chilean economy.  Even with the latest rally in copper prices, Chilean copper exports will continue contracting in US$ terms. The latest increase in prices will be more than offset by output cuts caused by social distancing rules and reduced staff in mines all over the country.  Bottom Line: Chile is shrouded in a cloud of political uncertainty. Monetary policy has reached its limits, and fiscal stimulus is insufficient for now. Investment recommendations Chart II-5Our CLP vs. USD Trade Continue shorting the CLP relative to a basket of the CHF, EUR and JPY. We closed our short CLP/USD on July 9th with a 29% profit (Chart II-5) and began shorting it versus an equal-weighted basket of the CHF, EUR and JPY. Within an EM equity portfolio, downgrade Chilean stocks from neutral to underweight. An ailing economy and political uncertainty will divert capital from the country despite attractive equity valuations. For an EM local bond portfolio, we are also downgrading Chile from neutral to underweight, as the risk of renewed currency depreciation is too large to ignore and downside in yields is limited due to the zero bound. Juan Egaña Research Associate juane@bcaresearch.com The Czech Republic: Pay Rates And Go Long The Currency An opportunity to bet on higher longer-term interest rates and on a stronger currency has emerged in the Czech Republic (Chart III-1). Consumer price inflation is above the central bank’s 2% target and will continue to rise, which will necessitate higher interest rates (Chart III-2). The latter will lead to currency appreciation. Chart III-1Pay Rates And Go Long CZK vs. USD Chart III-2Inflation Is Above The CB Bands   The Czech authorities’ strong fiscal and monetary support of the economy amid the COVID recession will keep both labor demand and, thereby, wages supported. In turn, core inflation will likely prove resilient in the near term and will rise over the coming 12-18 months, putting upward pressure on long-term interest rates. First, Prime Minister Andrej Babis is determined to promote a rapid economic recovery, as there are upcoming elections scheduled for next year. In early July, the government approved another spending program that will in part finance infrastructure projects and promote job creation in the non-manufacturing sector. The bill is expected to boost infrastructure spending by 140 billion koruna (or 2.5% of GDP) in 2020, and is part of a multi-decade national investment plan to increase domestic productivity. In particular, the construction sector will benefit from a massive uplift in domestic capex that will go towards upgrading the transport network. This will produce a job boom in the construction industry which should mitigate the employment losses in manufacturing and tourism. Second, shortages continue to persist in the labor market. Our labor shortage proxy is at an all-time high, suggesting that labor shortages will continue to facilitate faster wage growth (Chart III-3). Interestingly, Chart III-4 suggests that overall job vacancies have plateaued but have not dropped. This signifies pent-up demand for labor. Critically, this hiring challenge is likely to make industrial firms reluctant to shed workers amid the transitory pandemic-induced manufacturing downturn. Chart III-3Labor Shortages = Wages Higher Chart III-4Job Vacancies Are Holding Up   Either way, competition for labor in manufacturing and other sectors will keep a firm bid on both wages and unit labor costs in the medium to long term (Chart III-5). Third, low real interest rates will promote domestic credit growth (Chart III-6), helping support final domestic demand which, in turn, will lift inflation. Chart III-5Structural Pressure On Labor Costs Chart III-6Low Rates Will Bolster Domestic Demand   Similarly, residential real estate prices and rents will continue to grow at a hefty pace due to low borrowing costs and residential property shortages. Core inflation will likely prove resilient in the near term and will rise over the coming 12-18 months, putting upward pressure on long-term interest rates. Finally, core inflation measures are hovering well above the 2% target and the upper band of 3% (Chart III-2 on page 13). As such, the Czech National Bank (CNB) is likely to hike interest rates sooner rather than later. Critically, inflation is acute across various parts of the economy. Specifically, service price inflation is likely to continue rising in the wake of announced price hikes in public services, such as transport. These are being devised by local authorities to counteract a loss in tax revenue. Altogether, easy fiscal policy (infrastructure spending) will support labor demand, wage growth and final domestic demand, in turn heightening inflationary pressures. Unlike its counterparts in the EU, the CNB is more sensitive to price increases due to the relatively higher starting point of inflation in the Czech economy. As such, the central bank will be the first to hike interest rates among its EU counterparts, tolerating the currency appreciation that will come with it. The basis is Czech domestic demand and income growth will be robust. Investment Recommendation Czech swap rates are currently pricing a rise of only 55 bps in interest rates over the next 10 years. As a result, we recommend investors pay 10-year swap rates (see the top panel of Chart III-1 on page 13). We also recommend going long the Czech koruna versus the US dollar. Unlike the Czech central bank, the US Federal Reserve will keep interest rates very low for too long. In short, the Fed will fall well behind the curve, while the CNB will hike earlier. Rising Czech rates versus US rates favor the koruna against the dollar. This is a structural position that will be held for the next couple of years. It is also consistent with the change in our view on the USD, which has gone from positive to negative in our report from July 9. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1 Regarding Pakistan’s net financial inflows this year, we estimated that net foreign investment inflows, net foreign portfolio inflows and net other financial inflows to be about US$ 1.5 billion, US$ 0.5 billion, and US$ 10.5 billion, respectively, based on past data and the six-month outlook of the country’s economy. 2 Please see the following articles: Chinese Companies to Relocate Factories to Pakistan Under CPEC Project Importers Survey Shows Production Leaving China for Vietnam, Pakistan, Bangladesh   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese stocks are still in the “public participation phase” of a cyclical bull market and have not yet reached the “excess phase.” Economic fundamentals should provide support for more upside in Chinese stock prices in the next 6 to 12 months. Even if Chinese stocks evolve into a boom-bust cycle reminiscent of 2014-15, near-term technical price corrections should provide good buying opportunities. We remain overweight Chinese equities in both absolute and relative terms, and recommend investors increase their exposure to beaten-down cyclically-geared stocks, particularly in China’s domestic market.  Feature Chinese stocks rallied by 15% and 13% in the onshore and offshore markets, respectively, in the first 10 days of July. However, both markets gave up almost half of their gains in the third week of the month. The above-expectation Q2 GDP growth figure, which was released last Thursday, only exacerbated the market selloffs. This month’s rollercoaster ride in Chinese equities reminds investors of the boom-bust stock market cycle in 2014-2015, and raises the inevitable question: is it too late to buy or is it too early to sell Chinese stocks? We believe Chinese stocks are still at an early stage of a cyclical bull market.  While the recent near-vertical escalation in equity prices was clearly overdone, any near-term technical corrections will provide good buying opportunities. Three Phases Of A Bull Market Chinese bull markets typically last 2-2.5 years and involve three phases.1 The length and boundaries of each phase in a bull run are often blurred and are best identified in hindsight. However, this framework helps put the ongoing market rally in both A shares and investable stocks into perspective. In our view, the A share market is currently in the early stage of the “public participation phase”, whereas investable stocks seem to be halfway through (Chart 1A and 1B). Chart 1AA Shares In Early Stage Of The “Public Participation Phase (PPP)” Chart 1BChinese Investable Shares May Be Halfway Through PPP We think that the current bull market started in January 2019, following a bear market from 2016 to 2018. We upgraded Chinese stocks from neutral to cyclically overweight in April 2019, which was a couple of months into the “accumulation phase” of the bull market underway. The accumulation phase is the start of an uptrend, typically after a bear market, when smart money begins to buy stocks; fundamentals still look bleak and valuations are at exceptionally depressed levels. Chart 2China’s Economy Should Be On Track To A Cyclical Upturn The public participation phase typically exhibits a massive increase in trading volumes and explosive growth in new investor accounts. This phase begins when the market is already off the bottom and negative sentiment begins to wane on signs of economic improvement (Chart 2). As the bull trend is clearly established, technical and trend traders also begin to pile in, generating a self-feeding cycle. The market begins to feel overheated, making value investors uncomfortable, but valuations are not yet extreme (Chart 3). This phase tends to last longer than the other two stages in a bull market primary trend. The expansion of multiples remains the dominant driver for the broad market while earnings struggle (Chart 4). Chart 3Valuations In A Shares Are Not Too Extreme For investable shares, we believe that the bull market is probably more than halfway through the public participation phase (Chart 5). The market has decisively broken out of its key technical resistance and entered into expensive territory (Chart 6). Still, neither A-share nor investable markets seem to be in the “excess phase” as witnessed in 2015 (Table 1). Chart 4Market Returns Between Multiples And Earnings Growth: Chinese A Shares Chart 5Market Returns Between Multiples And Earnings Growth: Chinese Investable Shares Chart 6Valuations In Chinese Investable Shares Are Becoming Expensive, But Not Too Stretched Table 1Multiples In Chinese Stocks Are Not Yet In The “Excess Phase” China's short and volatile stock market history provides some classic examples of equity boom-bust cycles. The massive bull market in Chinese A shares between 2013 and 2016 fits the three phases perfectly: stock prices jumped by a whopping 93% in the three phases of the bull market between early 2013 and May 2015. The bull market eventually marched onto the excess phase in the first half of 2015 and reached the ultimate top in May 2015 with a trailing P/E of 25 and price-to-book of over 3. Bottom Line: Both the A-share and investable bourses still have room for upside in the ongoing bull market. Remain overweight on both investable and domestic shares, but domestic stocks have more latitude for rally as China’s economy and earnings continue to recover. Pullbacks Not Enough To Turn Bearish On July 1 we upgraded our tactical (0 to 3 months) call on Chinese stocks and initiated long Chinese domestic and investable stock trades relative to global benchmarks. While it is impossible to predict whether the current market will supercharge into a boom-bust cycle as seen in 2014-15, we intend to keep the trades given our conviction that cyclically there is still upside to Chinese stock prices. To turn cyclically bearish on Chinese shares, the following conditions need to develop: First, the broad market should reach an overvalued extreme, at which point gravity would set in. Some sectors and small-cap names, particularly in the ChiNext board, are currently stretched (Chart 7).  However, overall market valuations still appear reasonable, based on our composite valuation indicator. Historically, major peaks in the market occurred when the valuation indicator reached much higher levels. Further, cyclically-adjusted equity risk premiums (ERPs) in both Chinese onshore and offshore stocks are materially higher than their historical means (Chart 8). This suggests investors have already priced in extremely high uncertainties surrounding the Chinese economy. Perhaps overdone, in our view. As China's economy continues to recover, their ERPs should shrink, pushing stock prices higher. Chart 7A Structural Bull Run In Chinese Tech Stocks Chart 8Equity Risk Premium In Chinese Stocks Are Extremely High And Will Likely Shrink, Pushing Stock Prices Higher   Secondly, liquidity should tighten. An important liquidity source is margin lending, which has gone up exponentially since late June and invited regulatory attention (Chart 9). Instead of waiting for overleverage in the market to form a momentum like in the 2014 cycle, Chinese regulators seem to be more vigilant and restrictive this time. By acting early and removing some steam from recent market velocity, a healthier secular bull market can develop.   China’s overall monetary conditions are another important source of liquidity. If the policy stance turns from easing to tightening before the economy fully recovers, then it will lead to a compression in multiples in the equity market before stock prices can gain support from an earnings recovery. Historically, Chinese authorities tend to maintain an easing stance for at least three quarters following a nadir in the economy (Chart 10). The track record of Chinese policymakers suggests that the PBoC will likely keep monetary policy accommodative through the end of this year. Chart 9Chinese Authorities Have Been Cracking Down On Overleverage Early In This Bull Run Chart 10Easy Policy Should Sustain Through End Of 2020 Finally, the economy should weaken significantly, which would elevate the equity risk premium and threaten the earnings outlook. A second wave of COVID-19 would have to be severe enough to substantially impact China’s economic recovery, however, the pandemic situation in China seems to be contained and earnings recovery is on course (Chart 11, 12A, 12B, and 12C). Additionally, a major pandemic-triggered shock would only force Chinese authorities to up their ante on reflation and revive domestic demand, which could benefit stocks. Chart 11COVID-19 Virus Spread Has Been Largely Contained Within China Chart 12AA Share Prices Are Not Too Far Ahead Of Earnings Recovery Bottom Line: Chinese equities will likely experience technical corrections in the near term, but the downside risks are not enough to turn bearish.   Chart 12BChinese Investable Stock Prices Seem A Bit Ahead Of Its Own Historical Performance… Chart 12C…But Still Not Too Expensive Compared With Global Benchmarks Investment Conclusions Regardless of the direction of Chinese stocks in absolute terms, we recommend investors overweight equities within a global equity portfolio (Chart 13). Investors should also tilt their exposure to battered cyclicals, particularly in China’s domestic stock market (Chart 14). We favor consumer discretionary, materials and industrials in the next 6 to 12 months. Chart 13We Remain Overweight On Chinese Stocks Chart 14Cyclical Stocks Are Likely To Prevail Over Defensives Chinese equity prices have run ahead of economic fundamentals and setbacks will be likely in the near term. Still, these setbacks are buying opportunities and we recommend buying on the dip if Chinese equities, in either onshore or offshore markets, were to fall by 5% to 10% from current levels. However, consecutive selloffs accumulating to a 15% or greater fall in Chinese stock prices within a short period of time (e.g. 2 to 3 weeks) would prompt us to close our long Chinese equity trades. Historically, when the prices of Chinese equities fell by such a magnitude, the selloffs tended to trigger panic among China’s massive retail investors and, in turn, form a self-reinforcing downward spiral and push Chinese stocks into a prolonged bear market (Chart 15). Chart 15Oversized Selloffs Historically Tend To Push Chinese Stocks Into Prolonged Bear Markets   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Three Phases Of A Bull Market," dated April 22, 2015, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* Chart 4AIG Energy Risk Profile Chart 4BIG Integrated Risk Profile Chart 4CIG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile Chart 4FIG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth Chart 5BIG Integrated Debt Growth Chart 5CIG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth Chart 5FIG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* Chart 7AHY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile Chart 7EHY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth Chart 8BHY Independent Debt GrowthChart 8CHY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth Chart 8EHY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers Appendix B High-Yield Energy Issuers  

Highlights The yield advantage behind the dollar bull market since 2011 has completely evaporated. This has unhinged one of the final pillars of dollar support.  However, there is also a shifting paradigm in currency markets as nominal rates have hit zero –  the highest real rates can now be found in defensive currencies, where deflation is more pervasive. Most cyclical currencies are still sporting very negative real rates. In such a world, the most appropriate strategy is a barbell – overweighting the cheapest currencies, like the NOK and SEK, along with some defensives like the JPY. Trades at the crosses also make sense. We added a long CAD/NZD trade to our basket last week. Stick with it. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than a short DXY position. Feature Chart I-1Our Trading Model Is Bearish The Dollar Trading the foreign exchange markets can be complex and very humbling. That said, there are still some simple strategies that have consistently delivered excess returns over time. Regular readers of our bulletin are familiar with our framework based on three main vectors: the macroeconomic environment, valuation, and sentiment. Over time, a three-factor model based on these vectors has outperformed a buy-and-hold strategy for the majority of developed market currency pairs (Chart I-1).1 Within the model, an equal weight is assigned to all three factors, but the reality is that the most important variable to figure out is what the macro landscape will look like over a cyclical horizon. More often than not, the macro framework rather than valuation or sentiment is more important in timing turning points in currency markets. Over time, this can be a very potent source of alpha. Currencies, Inflation, And Real Rates Our starting point for figuring out the macro  environment is to go back to the four-quadrant chart splitting inflation and growth with the performance of currencies (Chart I-2). Two key observations stand out: Early on in any cycle, the dollar depreciates across most currencies. This is when growth is improving but inflation is still weak, allowing for very easy global monetary settings. As the cycle matures and deflationary pressures set in, a bullish dollar strategy is an absolute winner. In between an upcycle and a downturn, the performance of the dollar is more ambiguous. Trades at the crosses tend to do well in this environment. Chart I-2The Dollar, Fed, And Business Cycles The next step is to figure out which environment are we in today. An upturn is typically characterized by easy monetary settings and improving growth but weak inflation. This ensures the monetary impulse for growth remains at full throttle. The US dollar declines in this environment because the growth impulse is usually higher elsewhere, since the US has a lower manufacturing base. Early on in any cycle, the dollar depreciates across most currencies.  One way to figure out if we are early in the cycle is from the bond market. Early in the cycle, the cost of capital is well below the return on capital. This is the case for the US, where the NY Fed’s neutral rate estimate is well above the fed funds rate. Unsurprisingly, this correlates quite well with the yield curve, suggesting borrowing to invest makes sense. In the same vein, most economic leading indicators are perking up (Chart I-3). Given that inflation is not a problem today, the next key driver for currencies will be what happens to real growth. The yield advantage behind the dollar bull market since 2011 has completely evaporated. However, there is also a shifting paradigm in currency markets as nominal rates have hit zero – the highest real rates are now being found in defensive currencies (Chart I-4). For that to change, real rates have to rise in cyclical markets. The evidence so far is encouraging: Chart I-3Cost Of Capital Is Less Than Return On Capital Chart I-4Higher Real Rates In Switzerland And Japan   Relative PMIs outside the US are picking up faster than within the US (Chart I-5). In the euro zone, the improvement in the expectations component of the surveys are pointing to a very significant recovery in the PMIs in the months ahead (Chart I-6). China is stimulating aggressively. This is very potent fuel for domestic demand as well as global trade (Chart I-7).   Chart I-5Growth Is Outperforming Outside The US Chart I-6Eurozone Green Shoots Chart I-7China Green Shoots A pickup in real growth outside the US should improve bond yields in cyclical economies, encouraging flows into their capital markets. As we posited last week, an important component of these flows will also be into their equity markets, making the value-versus-growth debate very important for currencies.2 Coming back to our model, the main input into the macroeconomic component is real interest rate differentials. From this lens, the message so far is to remain long defensive currencies like the Swiss franc and Japanese yen that have the highest real rates. Measuring Value Chart I-8US Dollar Is Overvalued The macroeconomic component is only one of three factors – valuation and sentiment being equally important. Over the years, our team has compiled a swath of valuation models, which we follow quite closely. For the purposes of a simple framework, we stuck to purchasing power parity (PPP) when building out the valuation component. PPP is a very poor tool for managing currencies over the short term, but an excellent one at extremes. We have enhanced the computation to adjust for a few roadblocks that have proved crucial in adding value. Consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, an adjustment is necessary. This includes creating a synthetic price basket that looks at a very similar basket of goods and services across countries. If, for example, shelter is 33% in the US CPI basket but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, British pound, and Norwegian krone.  The results show the US dollar as overvalued, especially versus the Swedish krona, British pound, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc (Chart I-8). Using this valuation framework, long-term returns have been compelling. The bottom line is that while most cyclical currencies are still sporting very negative real rates, some are very undervalued from a cyclical perspective. This suggests the discount already accounts for negative real rates. Timing The Turning Point Turning points in foreign exchange markets tend to be most visible via capital flows. This makes the sentiment component of our model quite important. The nascent upturn in a few growth indicators is coinciding with an outperformance of value relative to growth and cyclicals versus defensive stocks. As we mentioned last week, it is an important signal to watch for currencies. Three ratios hold the key in determining when the dollar capitulates: The total return of US bonds versus gold, the USD/CNY exchange rate, and the gold-to-silver ratio (GSR). The  rationale for the three is as follows: As the Fed continues to increase the supply of bonds, the ratio of the US bond ETF (TLT)-to-gold (GLD) will be an important proxy for investor sentiment on the dollar. One of the functions of money is as a store of value, and gold remains a viable threat to dollar liabilities. Foreigners already have been stampeding out of US bond markets. A falling ratio will suggest domestic private investors are dumping their holdings in exchange for precious metals (Chart I-9). As geopolitical tensions between the US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, the USD/CNY is depreciating, suggesting dollar liquidity is providing a blanket cover over other ancillary issues. Finally, the gold-to-silver ratio correlates well with the dollar. Gold does well when there is financial stress in the system, forcing the Fed to undermine the value of the dollar through massive dollar supply injections. Silver does well when entities take advantage of cheap dollar funding to finance higher-return projects. It is a timely indicator about the liquidity-to-growth transmission mechanism (Chart I-10). Importantly, the new economy, technology, and clean energy industries are significant  buyers of silver . These industries are also cheaper outside the US, as we posited last week. Chart I-9Watch The Bond-To-Gold Ratio Chart I-10Watch The Gold-To-Silver Ratio In short, the huge directional indicator for the dollar bear market will be a crash in the GSR. This will act as both confirmation that the dollar bear market is full-fledged and that the tug-of-war between growth and liquidity is over. We have been highlighting this trade in recent months as one of our high-conviction calls. The sentiment component of our FX trading model uses a more traditional approach. As a momentum currency, signals like death crosses or bombed-out rates of change are potent. With the dollar in freefall, the signal is to keep selling. While it is true that speculators are already short, they were also long during most of the dollar bull market from 2011. Housekeeping Our currency strategy remains the barbell – overweighting the cheapest currencies like the NOK and SEK, along with some defensives like the JPY. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than an outright short DXY position. Our FX model, highlighted on the first page, suggests this will be the case. We have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. The macro landscape remains fraught with uncertainties, so we have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. Being long petrocurrencies versus the euro is also a nice carry trade. Finally, we were stopped out of our long cable position this week for a small profit of 2.4%. GBP has been one of our favorite contrarian trades, having booked 9.6% profits being long versus the yen last year. Volatility brings opportunity, and we will look to reestablish longs in the coming weeks.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report , "Introducing An FX Trading Model", dated April 24, 2020. 2 Please see Foreign Exchange Strategy Special Report , "Currencies And The Value-Vs Growth Debate", dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly positive: Headline consumer price inflation increased from 0.1% to 0.6% year-on-year in June. Core inflation was unchanged at 1.2% year-on-year. The NFIB business optimism index increased from 94.4 in May to 100.6. The NY Empire State manufacturing index surged from -0.2 to 17.2 in July. Producer prices fell by 0.8% year-on-year in June. Initial jobless claims increased by 1300K for the week ended July 10th. The DXY index fell by 0.7% this week. Risk sentiment continues to improve with higher hopes for vaccine and the reopening of economies. The Fed’s Beige Book released this Wednesday shows that economic activities are recovering in a lot of districts though well below pre-COVID-19 levels. It is remarkable that retail sales surged, led by a rebound in vehicle sales and home improvement purchases. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index ticked up from 58.6 to 59.6 in July. Industrial production fell by 20.9% year-on-year in May, following a 28.7% contraction the previous month.  The trade balance surged from €1.6 billion to €8 billion in May. The euro appreciated by 1.1% against the US dollar this week. The ECB kept policy unchanged this week. As interest rate spreads between the core and periphery converge, the ECB’s work is done. We remain positive on the euro against the US dollar, though petrocurrencies and the British pound will likely outperform should our bet on high-beta currencies pan out. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Industrial production plunged by 26.3% year-on-year in May, following a 25.9% contraction the previous month. Capacity utilization continued to fall by 11.6% year-on-year in May. The Japanese yen appreciated by 0.5% against the US dollar this week. The BoJ maintained its interest rate at -0.1% on Tuesday and made no changes to its asset purchase program. While Governor Haruhiko Kuroda warned the outlook remains highly uncertain (including downgrading the economic forecast for 2020), he sounded conciliatory to the fact that fiscal policy might be needed to boost Japanese demand. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The total trade surplus widened from £2.3 billion to £4.3 billion in May, boosted by a 6.6% jump in goods sales. Retail sales surged by 10.9% yearly in June. Both headline and core inflation increased to 0.6% and 1.4% year-on-year, respectively in June. The unemployment stayed flat at 3.9% in May. Average earnings fell by 0.3% year-on-year in the 3 months to May. However, industrial production fell by 20% year-on-year in May. The British pound was flat against the US dollar this week. The UK economy contracted by 19.1% in the three months to May, according to ONS data. GDP grew by 1.8% month-on-month in May alone, but this is still 25% below the February level. On the positive side, NIESR forecasts that the UK economy is likely to recover by 8-10% in the third quarter of 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: NAB business confidence increased from -20 to 1 in June. The business conditions index also jumped from -24 to -7. New home sales surged by 87.2% month-on-month in May. Employment increased by 210.8K in June, with an increase of 249K part-time jobs and a loss of 38.1K full-time jobs. The Australian dollar appreciated by 0.9% against the US dollar this week. The latest Labor Force Survey shows positive developments in recent months. While the unemployment rate ticked up slightly, both the underemployment rate and underutilisation rate declined by 1.4% and 1%, respectively in June. Moreover, the participation rate increased by 1.3% to 64%. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative:  Visitor arrivals plunged in May amid the global pandemic. ANZ monthly inflation gauge fell from 2.8% year-on-year to 2.4% year-on-year in June. Headline consumer price inflation slowed from 2.5% to 1.5% year-on-year in Q2. The New Zealand dollar fell by 0.2% against the US dollar this week. As we mentioned in last week’s report, the government’s effort to limit the spread of COVID-19 and curb immigration will hurt New Zealand’s labor market. The “Migration after COVID-19” released by NZIER this week also implied more restrictive immigration policy going forward. Stay short NZD/CAD. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: In June, the unemployment rate declined from 13.7% to 12.3%. The participation rate also increased from 61.4% to 63.8%. Manufacturing sales surged by 10.7% month-on-month in May, following a 27.9% decline the previous month. The Canadian dollar appreciated by 0.4% against the US dollar this week. On Wednesday, the BoC kept its benchmark interest rate unchanged, as widely expected. BoC’s new Governor Tiff Macklem said that “it’s going to be a long climb out” and implied that interest rates are likely to stay unusually low for a long time. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices declined by 3.5% year-on-year in June, following a 4.5% contraction the previous month. Total sight deposit continued to increase from CHF 687 billion to CHF 688.6 billion for the week ended July 10th. The Swiss franc fell by 0.2% against the US dollar this week. In a speech this Tuesday, SNB Chairman Thomas Jordan said that the current policy in place since 2015 is unlikely to change anytime soon. He also acknowledged that the SNB had intervened in the FX market more strongly in recent months to ease upward pressure on the franc amid the global pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Headline consumer prices increased by 1.4% year-on-year in June. Core inflation surged by 3.1% year-on-year in June, the highest since August 2016. Producer prices fell by 14.4% year-on-year in June, following a 17.5% contraction the previous month.  The trade deficit widened from NOK1.2 billion to NOK10.2 billion in June. Exports fell by 15.6% year-on-year while imports rose by 10%, with a surge in food and manufactured goods purchases. The Norwegian krone increased by 2% against the US dollar this week. While the Norwegian krone has rebounded by 22% since the March lows, it is still 7-10% cheaper compared with pre-COVID-19 levels. Our bias is that the Norwegian krone still has tremendous room to run towards its fair value. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Headline consumer price inflation rose to 0.7% year-on-year in June, from -0.4% in April. Food and non-alcoholic beverages inflation slowed from 3.9% year-on-year the previous month but remained high at 2.6% year-on-year in June. The Swedish krona jumped by 2% against the US dollar this week on the back of positive inflation data. A bit less than the Norwegian krone, the Swedish krona has increased by 13% since its March lows but is still far below the value prior to COVID-19. We maintain a positive stance towards both NOK and SEK. Our Nordic basket is now 11% in the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The EM equity benchmark’s concentration in the top six stocks – that in turn correlate with US FAANGM – has risen substantially. Hence, the outlook for US mega-cap stocks will continue to significantly impact the EM equity benchmark. US FAANGM stocks have been closely tracking the trajectory of – and share many other similarities with – previous bubbles. Hence, it is risky to dismiss the mania thesis. That said, it is impossible to know how long this equity mania will last, how far it will go and what will trigger its volte-face. Odds of a repeat of the 2015 boom-bust cycle in Chinese equities are low. The rally in Chinese stocks and commodities might be due for a pause. Feature Concentration Risk Chart 1EM: Mega-Caps Stocks Versus The Equal-Weighted Index The EM equity index's hefty gains since the late-March lows have largely been at the hands of about six stocks: Alibaba, Tencent, TSMC, Samsung, Naspers and Meituan-Dianping (Chart 1). The latter is a Chinese web-service platform company, while Naspers derives 75% of its revenue from its equity ownership in Tencent and 25% from a Russian internet company. For ease of reference, we refer to the big four (Alibaba, Tencent, Samsung and TSMC) as EM ATST. Table 1 illustrates that the top six companies combined account for about 24.3% of the MSCI EM equity market cap. For comparison, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) account for 25% of the S&P 500 market cap. The remainder of the EM equity universe – including all Chinese, Korean and Taiwanese stocks other than the six mega caps listed above – has rallied less (Chart 1). This is very similar to the dynamics in the US equity market, where the equally-weighted index has substantially diverged from the FAANGM index (Chart 2). Table 1Market Cap Weights & Performance Since March Lows Chart 2US: FAANGM Versus The Equal-Weighted Index   Table 2MSCI EM Stocks: Country Weights The EM ATST’s exponential rise has also boosted their respective country weightings in the MSCI EM equity benchmark. Table 2 demonstrates that China, Korea and Taiwan together account for 65% of the EM benchmark, India for 8% and all other 22 countries combined for 27%. Note that the market cap ($1.7 trillion) of the remaining 22 countries is almost as large as the market cap of the top six EM individual stocks. On the whole, concentration in the EM benchmark is as high as ever. Apart from global trade and Chinese growth, there are two other forces that will define the direction of EM mega-cap stocks: (1) rising geopolitical tensions between the US and China, and (2) a continuous mania or bust in “new economy” stocks. We discuss the latter in the following section. Escalating tensions between the US and China, including North Korea’s potential assault on South Korea, pose risks to Chinese, Korean and Taiwanese stocks. This is one of the critical reasons why we have been reluctant to chase these markets higher, despite upgrading our outlook on Chinese growth. If these bourses relapse, their sheer weight in the EM benchmark will pull the index down. The EM equity index’s outperformance in recent weeks has been due to the surge in both EM mega-cap stocks and Chinese share prices more broadly. Bottom Line: The EM equity benchmark concentration has risen substantially due to outsized gains in several “new economy” stocks. What’s more, the EM equity index’s outperformance in recent weeks has been due to the surge in both EM mega-cap stocks and Chinese share prices more broadly (we discuss the latter below). If the global mania in “new economy” stocks persists, EM ATST could well drive the overall EM equity index higher. Conversely, if “new economy” shares roll over for whatever reason, the EM equity benchmark’s advance will reverse. A Bubble Or Not? An assessment of the sustainability of the rally in US FAANGM stocks is critical for investors in the EM equity benchmark if for no other reason than the concentration hazard. We present the following considerations in assessing whether the FAANGM and EM ATST rally is or is not a mania: First, the exponential rally in FAANGM stocks is not a new phenomenon: It has been taking place over the past 10 years. Our FAANGM index – an equal-weighted average of six stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft) – has increased 20-fold in real (inflation-adjusted) US dollar terms since January 2010. Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index in the 1990s and Walt Disney in the 1960s, and well exceeds other bubbles, as illustrated in Chart 3. All price indexes on Chart 3 are shown in real (inflation-adjusted) terms. Chart 3Each Decade = One Mania All these manias and bubbles started with excellent fundamentals, and price gains were initially justified. Toward the end of the decade, however, their outsized gains attracted momentum chasers and speculators, catapulting share prices exponentially higher. Second, a financial mania requires: (1) solid past performance; (2) a story that can capture investors’ imaginations, and (3) plentiful liquidity. The “new economy” stocks fit all of these criteria: They have delivered super-sized performance over the past 10 years; They easily capture ordinary people’s imaginations – the average person on the street knows that FAANGM and EM ATST stocks benefit from people working from home and spending more time online; The Federal Reserve and many other central banks are injecting enormous amounts of liquidity into their respective economies. Third, there is a striking similarity between the FAANGM rally and previous bubbles: The mania-subjects of the preceding decades assumed global equity leadership early in their respective decade, rose steadily throughout, and went exponential at the very end of the decade. The latest parabolic surge in FAANGM stocks along with its duration (10 years of global equity outperformance and leadership) and magnitude (20-fold price appreciation in real inflation-adjusted terms) conspicuously resembles those of previous bubbles. Interestingly, the majority of previous bubbles peaked and tumbled around the turn of each decade, the exception being Walt Disney – the Nifty-Fifty bubble of the 1960s – which rolled over in 1973. Given FAANGM stocks have been closely tracking the trajectory of previous bubbles, it will not be surprising if 2020 ends up marking the peak for “new economy” stocks. Fourth, the last exponential upleg in the tech and telecom bubble of 1999-2000 occurred amid a one-off demand surge for tech hardware and software. The Y2K scare – worries that computers and networks around the world might malfunction on the New Year/new millennium eve – spurred many companies to order new hardware and upgrade their systems and networks. As a result, there was a one-off boom in orders in the global technology industry in the fourth quarter of 1999 and first quarter of 2000. Chart 4Orders For Computers And Electronics Have Remained Resilient Investors extrapolated this one-off demand surge into the future, mistaking it for recurring growth. As a result, they assigned extremely high valuations to these tech stocks in the first quarter of 2000. Similarly, since March, working and shopping from home has sharply increased demand for web services, online shopping, cloud computing and tech hardware. The top panel of Chart 4 demonstrates that US manufacturing orders for computers and electronic products did not contract in the March-May period, while orders for capital goods have plunged since March. Similarly, Taiwanese exports – which are heavy on tech hardware – are holding up well despite the crash in global trade (Chart 4, bottom panel). Some of this demand strength is structural, but part of it is one-off and non-recurring. Certainly, one should not extrapolate their recent growth rates into the future. However, investors are prone to extrapolation and chasing winners. Fifth, valuations of US FAANGM and EM ATST are elevated. Trailing P/E ratios for EM ATST stocks are shown in Table 3. Table 3Price-To-Earnings For Top 6 EM Stocks All in all, provided both US FAANGM and EM ATST consist of admirable companies with great competitive advantages and business models, it is tempting to dismiss the bubble argument. Nevertheless, there are enough similarities with previous manias to compel investors to be vigilant. Even great companies have a fair price, and substantial price overshoots will not be sustainable. We sense a growing number of investors deem US FAANGM and EM ATST stocks as invincible. When some stocks are regarded as unbeatable, their top is not far. Our major theme for the past decade – elaborated in the report, How To Play EM In The Coming Decade1 published in June 2010 – has been as follows: Sell commodities / buy health care and technology. Until 2019, we were recommending being long EM tech/short EM resource stocks. Unfortunately, since 2019, the corrections in EM “new economy” stocks have proved to be too short and fleeting, and we were unable to buy-in. Their share prices have lately gone parabolic: They are now in a full-blown mania phase. As to global equity leadership change from growth to value stocks, we maintain that major leadership rotations typically occur during or at the end of an equity selloff, as we elaborated in our October 3, 2019 report (Charts 5 and 6). Chart 5EM vs DM: Leadership Rotation Requires Market Turbulence Chart 6Growth vs Value: Leadership Rotation Requires Market Turbulence Apparently, the February-March selloff did not produce a shift in equity leadership. Barring a major selloff, “new economy” stocks will likely continue to lead. Chart 7Fed Rate Cuts Did Not Prevent The S&P 500 Bubble From Unravelling Finally, easy money policies encourage speculation and contribute to the build-up of manias. However, when a bubble starts unravelling, low interest rates are often unable to avert the bust. For example, when the tech bubble began bursting in 2000, the Fed cut rates aggressively and US bond yields plunged. Yet, low interest rates did not prevent tech share prices from deflating further (Chart 7). Bottom Line:  It is impossible to know how long this equity mania will last, how far it will go and what will trigger its volte-face. One thing is certain: there is a lot of froth – particularly in terms of valuation and positioning – in these “new economy” stocks. Yet, these excesses could last longer and get larger. A Mania In Chinese Equities? Many commentators have rushed to compare the latest surge in Chinese stocks with the exponential advance in the first half of 2015. We do not think this rally will go on without interruption for another five months like it did back then. Our rationale is as follows:   The Chinese authorities are much more vigilant now, and they will try to induce periodic corrections to avoid another mania and bust similar to those that occurred five years ago. The Chinese authorities are much more vigilant now, and they will try to induce periodic corrections to avoid another mania and bust similar to those that occurred five years ago. Both China’s MSCI Investable and CSI 300 equity indexes are retesting their previous highs (Chart 8). In the past they failed to break above these levels, and this time is likely to be no different, at least for now. The latest spike is more likely to be the final hurrah before a setback. Critically, the 12-month forward P/E ratio for China’s MSCI Investible index has also risen to its previous peaks (Chart 9, top panel). This has occurred with little improvement in the 12-month forward EPS (Chart 9, bottom panel). In short, share prices have run ahead of the business cycle and are already pricing in a lot of profit recovery. Chart 8Chinese Stocks Are At Their Previous Highs Chart 9Chinese Investable Stocks: A Rally Driven By P/E Expansion Chart 10Chinese Onshore Stocks: A Two-Tier Market Most of the rally since the March lows has been due to “new economy” stocks. Share prices of “old economy” companies did not do that well before July. Tech stocks in the onshore market have gone parabolic (Chart 10, top panel). This contrasts with lackluster performance of materials, industrials, and property stocks (Chart 10, bottom panels). Critically, in the onshore market, tech stocks are trading at the following trailing P/E ratios: the market cap-weighted P/E is 155, and the median P/E is 60. Needless to say, these valuations are outright expensive.   Bottom Line: Odds of a repeat of the 2015 boom-bust cycle are low. The rally in Chinese stocks might be due for a pause. On June 18, we upgraded Chinese stocks to overweight from neutral within the EM benchmark, a recommendation that remains intact. We have a much lower conviction on the absolute performance of Chinese stocks in the near-run. China And Commodities An important question to address is whether the rally in commodities in general and copper in particular are signals of a sustainable recovery in the mainland economy. Without a doubt, economic conditions in China have been improving, and infrastructure spending has been accelerating. However, the magnitude of the upswing in copper prices is excessive relative to the strength of the Chinese economy. The spike in resource prices in general and copper in particular has been due to three forces: (1) China’s unprecedented super-strong imports; (2) global investors buying commodities; and (3) output cuts. It is highly unlikely that commodity demand in China is this strong. In our opinion, this reflects restocking. Chart 11 shows that Chinse imports of copper and copper products surged by 100% in June from a year ago, while imports of steel products increased by 100% and oil import volumes rose by 34%. It is highly unlikely that commodity demand in China is this strong. In our opinion, this reflects restocking. Provided cheap credit availability, wholesalers, intermediaries or users of commodities have rushed to buy before prices rise further. In the case of copper, it will take several months before the real economy absorbs that much of the red metal. Hence, China’s copper imports are poised to relapse in the coming months.   Chart 12 illustrates that investors’ net long positions in copper have risen to their highest level since early 2019. Consistently, the July Bank of America/Meryl Lynch Global Fund Manager Survey revealed that as of early July, portfolio managers had built up their largest net long positions in commodities since July 2011.   Not only oil but also copper and iron ore prices have benefitted from production declines. Due to surging COVID infections, Chile and Peru have sharply reduced copper output and Brazil has curtailed iron ore production. Chart 11Chinese Imports Of Commodities Have Surged Chart 12Investors Have Gone Long Copper Simultaneous buying of commodities by China and global investors as well as production cuts have considerably benefited resource prices as of late. Our suspicion is that commodities inventories in China have become elevated. This entails reduced purchases by China, and by extension an air pocket in commodities prices in the months ahead. Bottom Line: The rally in resources in general and copper in particular is at risk of a correction. We remain long gold/short copper.     Investment Strategy In absolute terms, the risk-reward of EM share prices is not attractive. However, as we have argued in the past two months, FOMO (fear-of-missing-out) mania forces could take share prices higher. The timing of a reversal is never easy especially when a FOMO-driven mania is alive. For now, for asset allocators we reiterate a below-benchmark allocation in EM stocks within a global equity portfolio. However, a breakdown in the trade-weighted US dollar will prompt us to upgrade EM within the global equity benchmark (Chart 13). The broad trade-weighted dollar is teetering on an edge but has not yet broken down (Chart 14). In sum, global equity portfolios should be ready to upgrade their EM allocation to neutral on signs that the broad trade-weighted US dollar is breaking down. Chart 13EM vs DM: Is The Downtrend Intact? Chart 14The Broad Trade-Weighted Dollar Is On An Edge   As we argued last week, the US dollar could weaken against DM currencies amid the next selloff in global share prices. This is why last week we switched our short positions in an EM currency basket from the US dollar to an equally-weighted basket of the euro, the Swiss franc and Japanese yen. This strategy remains valid. The US dollar is at risk versus DM currencies. However, EM exchange rates may not be out of the woods, given their poor fundamentals on the one hand and potential geopolitical risks in North Asia on the other. We are neutral on both EM local currency bonds and EM sovereign and corporate credit.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Please see Emerging Markets Strategy Special Report "How To Play EM In The Coming Decade," dated June 10, 2010. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations