Mega Themes
Feature Chart 1Stock Prices Are Struggling To Break Out Of Their Recent Highs Stock prices in China's onshore and offshore markets rallied into the New Year (Chart 1). Despite the strong performance in the last couple of days, as we pointed out in our 2021 Outlook Report, the biggest obstacle that Chinese stock prices face is their elevated valuations against tightening macro policy. Recent liquidity injections by the PBoC have prompted a sharp drop in the 7-day repo rate. However, slightly loosened liquidity conditions in the interbank system do not signify a shift in monetary policy, i.e. financial conditions will continue to tighten in 2021, albeit at a slower rate than in the second half of 2020. The Central Economic Work Conference (CEWC) wrapped up its December meeting with a pledge to maintain continuity, stability and sustainability in macroeconomic policy without making any “sudden turns”. The conference release also stated that China “must use the valuable time window to focus on reform and innovation — achieving a good start for the 14th five-year plan in terms of high-quality development.” The CEWC’s messages align with our baseline view that Chinese policymakers are not yet in a deleveraging mood. The country’s macro leverage level should be kept stable in 2021 and the growth of credit creation will decelerate gradually (Chart 2, Scenario 1). The pullback in this year’s fiscal support will also be gentle: we expect newly issued special purpose bonds (SPBs) to reach 3.2-3.5 trillion in 2021, about 10% less than the 3.75 trillion issued in 2020. This will put the 2021 SPB quota in the same range as in 2016, but higher than in 2017, 2018 or 2019 (Chart 3). Chart 2Credit Growth Will Decelerate In 2021 Chart 3Fiscal Cliff In 2021 Unlikely A credit or fiscal cliff is unlikely this year. Instead, we expect the authorities to accelerate key reforms such as a clampdown on market monopolies and housing speculation in large cities, heavier penalties on capital market violations and a reduction in carbon emissions. In the long run, these reforms may help to rebalance China’s economic structure, but in the near term, a more stringent policy backdrop will probably hinder investors’ appetites for Chinese risk assets. In early December, we downgraded Chinese equities from overweight to neutral for the next 0-3 months, in both absolute and relative terms. We will evaluate our cyclical call on Chinese stocks in the coming weeks. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Below is a set of market relevant charts along with our comments: The PBoC has injected large amounts of liquidity into the interbank system since mid-November, helping to sharply lower the short-term interbank repo rate. We pointed out previously that policy rates had breached their pre-pandemic levels by November while the economy had barely expanded from the end of 2019. Thus, we expected the PBoC to slow the pace of interest rate normalization in Q4. Recent liquidity injections likely were related to preventing a year-end cash crunch in the financial system, not a change in the PBoC’s planned pace of policy tightening. While the 7-day interbank repo rate is back to its June 2020 level, the 3-month SHIBOR (the de facto policy rate) has only slightly moderated. The divergence between the 7-day and the 3-month interbank rates was also apparent during the monetary tightening cycle in 2017-2018. During that cycle, the jump in the 3-month SHIBOR pushed up government bond yields and bank lending rates, while the 7-day repo rate remained stable. As shown in a previous report, the 3-month SHIBOR more tightly correlates with bond yields and is a better measure of China’s monetary policy stance. Chart 4The Short-Term Interbank Repo Rate Dropped Sharply Since Mid-November … Chart 5… But The Declines In The 3-Month SHIBOR And Bond Yields Have Been Much Milder Chinese onshore stock prices trended sideways for most of December, even as the PBoC loosened interbank liquidity conditions in mid-November. Chinese offshore stocks have also failed to break out from highs reached in November, as tech giants such as Alibaba and Tencent have come under tough scrutiny from regulators. Chinese stocks will continue to experience a tug-of-war between tailwinds and headwinds in the next three months. The relatively well-contained domestic pandemic and improving economic growth will support investors’ sentiments towards Chinese risk assets. At the same time, stock prices will face headwinds such as elevated valuations, a more restrictive policy environment and wider corporate credit spreads. For now, the downside risks to Chinese stocks prevail. Chart 6ADomestic Stocks Are No Longer Cheap Chart 6BElevated Valuations In Investable Stocks Tailwinds Supporting Chinese Stocks: Economic Recovery To Continue In 1H21 Chart 7China’s EPS Recovery To Continue In 1H21 China’s business cycle will remain resilient in the first half of 2021 while existing stimulus measures continue to work their way into the real economy. In the next six months, some laggards in the economic recovery, such as the service sector and household consumption, will likely pick up momentum, while the manufacturing and export sectors remain robust. China’s export sector should maintain strong growth momentum in the first half of the year. A rising RMB exchange rate may eventually impede the price competitiveness of some labor-intensive export goods , but Chinese manufacturers will continue to fill the gap between global demand and supply before the COVID-19 vaccines are widely distributed and the global supply chains are fully recovered. Moreover, China’s global share of exports gradually rose in both 2018 and 2019 despite the Sino-US trade war. Data from Q4 show that Chinese exports have been robust beyond pandemic-related goods. As the global economy and demand growth pick up next year, Chinese exports should also benefit from the trade recovery. Chart 8The Strength In Chinese Exports Has Expanded Beyond Pandemic-Related Goods … Chart 9… And Will Benefit From Recovering Global Demand In 2021 Chart 10The Acceleration In Completed Housing Will Support Construction In 1H21 An acceleration in completing existing projects should support the construction sector in the first half of 2021, despite a slower expansion rate in new development projects. Floor space completed has significantly lagged floor space started and sold during the past two years, while real estate developers rushed to acquire new projects, land and down payments to expand their market share. Property developers will need to speed up the completion process of existing projects to bring leverage in line with the “three red lines” imposed since August 2020 (housing presales need to be excluded from the liability-to-asset ratio calculation). Hence, we expect the growth in real estate investment and construction activities to remain stable through the first half. Chart 11Smaller Cities Face Less Upward Price Pressure on Housing Prices Than Big Cities Chart 12Housing Restrictions Will Be Most Stringent In Top-Tier Cities Chart 13The Laggards In The Economy Are Firming Up The laggards in the economy are firming up. Recent economic data show that growth momentum is shifting from leaders in the economic recovery, especially old-economy sectors such as infrastructure and real estate, to the coincident and lagging sectors such as manufacturing and consumer sectors. While an increase in these sectors is positive for the economy and the growth of corporate profits, it also implies that the economic recovery has entered a late phase and a peak in the business cycle is near. Therefore, the improvements do not necessarily provide enough impetus for stock prices to trend higher, and prices may be at risk from a policy overkill. Chart 14Household Consumption Still Has Room To Improve Chart 15Sales Of Discretionary Goods Have Surged Downside Risks To Chinese Equity Prices China’s domestic policy environment has turned less favorable for risk assets. A new round of policy tightening is well underway as suggested by a slew of events, ranging from the recent SOE bond payment defaults to regulators suspending the Ant Group IPO and cracking down on market monopolies. Investors will likely be risk averse in the near term. Chart 16Stringent Scrutiny On Tech Companies Hammered Their Stock Performance … Chart 17… Bringing Down Their Sector Performance Rising corporate bond yields in China’s onshore bond market are not an impediment to increasing Chinese share prices as long as forward EPS net revisions are also climbing. Not only have onshore corporate bond yields recently risen, but forward EPS net revisions have rolled over. Such a combination does not bode well for Chinese equities. Chart 18Red Flag For Chinese Equities The impact from stricter lending regulations in the real estate sector may start impeding home sales and new real estate investment into the second half of the year. Effective January 1, 2021, China imposed caps on bank loans to real estate developers. Loans will be capped at 40% for the largest state-owned lenders, while banks’ mortgage lending should be no more than 32.5% of their outstanding credit. The regulations are even more rigorous for smaller banks.1 The new rules highlight the authorities’ determination to curb financial risks derived from the housing market and are a step up from the existing deleveraging pressures faced by property developers. Bank loan quotas under the new rules are in line with ones used in 2020.2 However, based on our projections that overall credit growth will decelerate by at least 2 percentage points in 2021 compared with 2020, there will be a corresponding decrease in real estate sector’s borrowing from banks. Bank loans account for roughly 14% of real estate developers’ total funding sources and household mortgages accounted for 16% in 2020. When deleveraging pressures are on and financing resources are capped from both the supply and demand sides, real estate investment growth will likely peak no later than mid-2021. Chart 19The New Rules May Exacerbate The Downward Trend In Bank Loans To The Real Estate Sector This Year Deflationary pressures may resurface in the second half, which would be a downside risk to China’s corporate profit growth. The producer prices contraction will continue to narrow and even turn mildly positive in the next six months, supported by the uptrend in the business cycle and a low base factor in 1H20. However, both consumer and producer prices may face renewed downward pressures in the second half of 2021 when the business cycle is expected to peak and the effects of stimulus gradually fade. Moreover, the RMB appreciation will add to headwinds faced by producer prices in 2021. Chart 20While The Ongoing Economic Recovery Will Support Prices In 1H21 … Chart 21… Lower Money Growth And Higher RMB Value May Start To Hurt Prices In 2H21 Chart 22Resurfaced Deflationary Pressure Will Create Downside Risk To China’s Corporate Profit Growth In 2H21 Chart 23The Outperformance In Cyclical Stocks Versus Defensives Has Rolled Over The outperformance in cyclical stocks relative to defensives in the investable stocks recently rolled over. Historically, there is a strong link between forward earnings and stock price performance of cyclical sectors, while defensives have a low equity return beta and are market neutral. A switch in outperformance from cyclicals to defensives usually corresponds with the economy shifting from an expansionary to contractionary phase. Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives may be an early sign that Chinese stock performance has lost its momentum in the current cycle. In relative terms, as breakthroughs in vaccines make the pandemic less threatening to the global economy, cyclical stocks outside of China will start to benefit from improvements in business activities. This will make Chinese risk assets relative to global ones less appealing. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes 1For second-tier banks, including state-owned Agricultural Development Bank of China and Exim Bank of China, and 12 joint-stock holding commercial banks, caps on loans to developers and mortgage loans are 27.5% and 20% respectively. Meanwhile, the ratios are capped at 22.5% and 17.5% respectively for smaller city and rural commercial banks, rural cooperative banks and credit cooperatives. The strictest limits apply to small village banks, which can lend only 12.5% of their portfolios to real estate developers and 7.5% to homeowners. 2Currently, outstanding loans to the real estate sector (including household mortgage loans) account for about 29% of total loans from China’s financial institutions, while the ratio of housing mortgage loans is 22%. Cyclical Investment Stance Equity Sector Recommendations
Feature Feature ChartEconomies Have Already Snapped Back In this final report of a tumultuous 2020, we present our key views for 2021 in the form of ten questions and answers during a recent conversation with a client. 1. Let’s begin with a blunt question. How can your views ever anticipate a shock such as this year’s once-in-a-century pandemic? Nobody can predict when, where, or how a shock will come. But what we can, and should, always do is gauge the fragility of the market to an incoming shock, whatever that unknown shock might be. Before the pandemic struck, both our 2020 key views and our first report of this year, Markets Are Fractally Fragile, pointed out that a fragile market was vulnerable to “the tiniest of straws that could break its back.” Right now, markets are close to a similar point of fragility. 2. What is the specific source of market fragility right now? The fragility is that tech stock valuations have become hyper-dependent on low bond yields in a so-called ‘rational bubble’. Specifically, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous fragilities in February 2018, October 2018, April 2019, and January 2020 (Chart I-2). Chart I-2Tech Stock Valuations Are Fragile These previous fragilities resulted in an exhaustion, or worse, a correction, in tech stocks, and by extension in the overall market. The upshot is that a meaningful rise in bond yields could once again undermine the stock market. 3. But I thought that higher bond yields were good for stocks, if the higher bond yields imply that growth is accelerating? Not necessarily. Yes, a stock price is proportional to growth, but it is also inversely proportional to the discount rate, which is the required return that investors demand to hold it. If the discount rate increases by more than growth, then the stock price will fall, not rise. The discount rate equals the bond yield plus the equity risk premium. At ultra-low yields, the two components move together. This is because when the bond yield declines towards its lower bound, the bond price carries less upside versus downside and thereby more risk. Meaning that in relative terms, equities require a smaller risk premium. When bond yields increase, the opposite is true – both the bond yield and the equity risk premium rise together (Chart I-3). Chart I-3AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Chart I-3BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The result is that growth would have to increase very sharply to counter the large rise in the bond yield plus equity risk premium. 4. But 2021-22 are likely to be years of very strong growth just like the post-recession years 2009-10, right? Wrong. You see, after a slump the strongest growth occurs in the sharp snapback of lost output, and most of this sharp snapback has already happened. In 2008-09, the US and German economies shrank for four quarters. It then took five quarters of strong growth to recover two-thirds of this lost output. But in 2020, everything has happened at quintuple-speed. It has taken just one quarter to recover two-thirds of the lost output, and by the end of this year US GDP will be almost back to its pre-pandemic level (Feature Chart and Chart I-4). Chart I-4Economies Have Already Snapped Back This is because we quickly realised that even in a full-scale pandemic, 90 percent of economic activity can continue with face masks and social distancing. The activities that are most disrupted – retail, hospitality, and transport – account for just 10 percent of output. Meanwhile, China, which on some measures is the world’s largest economy, is already ‘back to normal’ because its effective track-and-trace system has circumvented the need for face masks and social distancing. The upshot is that, as far as global economic output is concerned, most of the powerful snapback has already happened. 5. But if economic output has largely recovered, why does it not feel like it has? For three reasons. First, the most disrupted activities comprise so-called ‘social consumption’ such as going to bars and restaurants, having friends round for dinner, and going on holiday. In other words, all the fun things in life. Although these activities account for just 10 percent of economic output, they likely account for a much bigger proportion of our happiness. Second, we are producing and consuming the 90 percent of undisrupted output differently. For example, working from home, doing business meetings virtually, and doing our shopping on-line. Crucially, much of this ‘new-normal’ is here to stay even when the pandemic ends. Third, although the disrupted activities account for just 10 percent of output, they account for a very significant 25 percent of all jobs. Meaning that the jobs market has not snapped back to the same extent as output. Indeed, permanent unemployment continues to rise (Chart I-5). Chart I-5Permanent Unemployment Continues To Rise Alas, the jobs market will take a long time to fully recover even when the pandemic ends. This is because the new-normal way of producing and consuming will permanently scar traditionally high-employment sectors such as retail and hospitality. Constituting a major economic fragility in the new-normal (Table I-1). Table I-1Retail And Hospitality Employ 25 Percent Of All Workers 6. All of which means inflation stays below the 2 percent target, right? Right. But your question should be framed differently. You see, inflation is a non-linear system with two states: price stability and price instability. You can shift an economy between these two states, but you cannot hit an arbitrary target like 2 percent, 3 percent, or 5 percent. So, your question should be, will developed economies stay in the state of price stability? And the answer is yes, because it is the much better state to be in, and it took decades of blood, sweat and tears to achieve. Nevertheless, any government can flip its economy into the state of price instability if it so desires. Just look at Turkey. A warning sign is that the central bank loses its independence, enabling it to monetise government debt. That’s the warning sign to look out for. 7. Talking of fragility in a new-normal, hasn’t the double whammy of Brexit and the pandemic weakened the EU? No, quite the contrary. As Jean Monnet, a founding father of the EU, said: “Europe will be forged in crises.” And he was right. Each of the last three crises has strengthened the EU’s architecture. The euro debt crisis added the missing ‘lender of last resort to sovereigns’ weapon into the ECB armoury – a weapon whose mere presence means it has never had to be used. Brexit removed the most troublesome member from the EU fold, as well as demonstrating how costly it is to exit. And the pandemic has allowed the EU to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. All of which means that the yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately disappear altogether (Chart I-6). Chart I-6The Yield Spread On Euro Periphery Bonds Will Vanish 8. What about the prospects for the UK outside the EU? Like all divorces, Brexit is a gain of self-determination for a loss of wealth. Hence, since the Brexit vote in 2016, the UK economy has flipped from outperformer to underperformer (Chart I-7). Chart I-7The UK Economy Has Flipped From Outperformer To Underperformer The UK economy will continue to underperform until it forges a fresh purpose and role as a newfound singleton on the world stage. 9. Turning to investments, will the 2020 losers become the 2021 winners, and vice-versa? No, that’s an over-simplification. For example, for bonds to lose their 2020 winnings, yields would have to back up a lot. But as we’ve already discussed, that would burst the ‘rational bubble’ in tech stocks, undermine the stock market, and put renewed downward pressure on bond yields. In which case, banks will struggle to sustain any outperformance (Chart I-8). Meaning that ‘value’ will struggle to sustain any outperformance. Hence, a much smarter strategy is to switch between winners and losers within ‘growth’ and within ‘value’. Specifically, overweight healthcare versus tech, and overweight utilities versus banks. Chart I-8Bank Relative Performance Tracks The Bond Yield Of course, sector allocations always carry implications for regional and country equity allocation. The main implications are to overweight Europe versus Emerging Markets (Chart I-9), and to overweight Developed Markets versus Emerging Markets. Chart I-9Europe Vs. EM = Healthcare Vs. Tech 10. Finally, what about your long-term recommendations? This brings us full circle to the first question. While we could not predict the pandemic, all our four mega-themes for the 2020s proved to be successful, and in some cases very successful. A hypersensitivity to higher interest rates. Overweight equities versus bonds. Europe conquers its disintegration forces. Overweight European currencies. Non-China exposed investments outperform. Underweight materials and resources. The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Given their long-term nature, these structural recommendations are as appropriate today as they were a year ago. And with that, it is time to sign off on a tumultuous 2020 and usher in 2021, a year which we define as Fragility In A New-Normal. We wish you and your families a safe and healthy holiday season, and a less tumultuous 2021. Fractal Trading System* This week’s recommended trade is to go long US utilities (XLU) versus US materials (XLB). Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short European retail (EXH8) versus the market (STOXX) achieved its 4.2 percent profit target at which it was closed. The rolling 12-month win ratio now stands at 61 percent. Chart I-10 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns