Business Cycles

Highlights The Eurozone economy and assets remain beholden to the global manufacturing cycle. This sensitivity reflects the large share of output generated by capex and exports. Yet, the second half of 2021 and first half of 2022 could see euro area growth follow the beat of its own drum. This is a consequence of the unique role of consumption in the COVID-19 recession. European growth will therefore outperform expectations, even if economic momentum slows outside of Europe. Consequently, the euro and Eurozone equities will outperform for the coming 12 to 18 months. Feature For the past 20 years, investors have used a simple rule of thumb to understand European growth and markets. Europe is a derivative of global growth because of its large manufacturing sector and torpid domestic economy. A reductionist approach would even argue that China’s economy is what matters most for Europe. Is this model still valid to analyze Europe? In general, this approach still holds up well. However, the nature of the 2020 COVID-19 recession suggests that the European economy could still accelerate in the second half of the year, despite a small slowdown in the Chinese economy and global manufacturing sector. The Origin Of The Pro-Cyclicality Narrative Investors in European markets have long understood that Eurozone equities outperform when the global manufacturing cycle accelerates. This pro-cyclicality of European stocks is a consequence of their heavy weighting toward cyclical and value stocks, such as industrials, consumer discretionary and financials. Chart 1German/US Spreads: Global Manufacturing Cycle German/US Spreads: Global Manufacturing Cycle German/US Spreads: Global Manufacturing Cycle Historically, European yields have also moved in a very pro-cyclical fashion. Over the past 30 years, periods when German 10-year yields rose relative to that of US Treasury Notes have coincided with an improvement in the global manufacturing sector as approximated by the ISM Manufacturing survey (Chart 1). Investors also understand that the euro is a pro-cyclical currency. Some of this behavior reflects the counter-cyclicality of the US dollar. However, if German yields rise more than US ones when global growth improves and European equities outperform under similar conditions, the euro naturally attracts inflows when the global manufacturing sector strengthens. Chart 2China Is A Key Determinant Of European Activity China Is A Key Determinant Of European Activity China Is A Key Determinant Of European Activity Ultimately, the responsiveness of the euro and European assets to global growth is rooted in the nature of the European economy. Trade and manufacturing account for nearly 40% and 14% of GDP, respectively, compared to 26% and 11% for the US. This economic specialization has made Europe extremely sensitive to the gyrations of the Chinese economy, the largest contributor to fluctuation in the global demand for capital goods. As Chart 2 highlights, European IP and PMI outperform the US when China’s marginal propensity to consume (as approximated by the growth in M1 relative to M2) picks up. Is The Pro-Cyclical Narrative Still Valid? Despite the euro area debt crisis and the slow health and fiscal policy response of European authorities to COVID-19, evidence suggests that the Eurozone’s pro-cyclicality is only increasing. Chart 3Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World Europe Is Becoming More Sensitive To The Rest Of The World A simple statistical analysis confirms this hypothesis. A look at the beta of European GDP growth against the Global PMI reveals that the sensitivity of Eurozone growth and German growth to the Global PMI has steadily increased over the past 20 years (Chart 3, top panel). Moreover, the beta of euro area growth to the global PMI is now higher than that of the US, despite a considerably lower potential GDP growth, which means that a greater proportion of the Eurozone’s GDP growth is affected by globally-driven fluctuations. The bottom panel of Chart 3 shows a more volatile but similar relationship with Chinese economic activity. Correlation analysis confirms that Europe remains very sensitive to global factors. Currently, the rolling correlation of a regression of Eurozone GDP growth versus that of China stands near 0.7, which is comparable to levels that prevailed between 2005 and 2012. The correlation between German and Chinese GDP growth is now higher than at any point during the past two decades. Chart 4The Declining Role Of Consumption The Declining Role Of Consumption The Declining Role Of Consumption The increasing influence of global economic variables on the European economy reflects the evolution of the composition of the Eurozone’s GDP. Over the past 11 years, the share of consumption within GDP has decreased from 57% to 52%. For comparison’s sake, consumption accounts for 71% of US GDP. The two sectors that have taken the primacy away from consumption are capex and net exports, whose combined share has grown from 22% to 26% of GDP (Chart 4). This shift in the composition of GDP echoes the structural forces facing the Eurozone. An ageing population, a banking system focused on rebuilding its balance sheet, and the tackling of the competitiveness problems of peripheral economies have hurt wage growth, consumption and imports. Meanwhile, exports have remained on a stable trend, thanks to both the comparative vigor of the euro area’s trading partners and a cheap euro. Therefore, net exports expanded. Capex benefited from the strength in European exports. A Granger causality test reveals that consumption has little impact on fixed-capital formation in the euro area. However, the same method shows that fluctuations in export growth cause changes in investment. This makes sense. The variance in exports is an important contributor to the variability of Eurozone profits (Chart 5). Thus, rising exports incentivize the European corporate sector to expand its capital stock to fulfill foreign demand. The expanding share of output created by exports and capex along with the role of exports as a driver of capex explains why Europe economic activity is bound to remain so sensitive to the fluctuations in global trade and manufacturing activity. Moreover, the capex/exports interplay even affects consumption. As Chart 6 shows, the growth of euro area personal expenditures often bottoms after the annual rate of change of the new orders of capital goods has troughed, which reflects the role of exports as a driver of European income. Chart 5Profits And Exports Profits And Exports Profits And Exports Chart 6Consumption Doesn't Move In A Vacuum Consumption Doesn't Move In A Vacuum Consumption Doesn't Move In A Vacuum Bottom Line: European economic activity remains a high beta play on global and Chinese growth. The decrease in consumption to the benefit of exports and capex explains why this reality will not change anytime soon. 2021, An Idiosyncratic Year? In 2021, consumption will be the key input to the European economic performance, despite the long-term relationship between European GDP and foreign economic activity. This will allow European growth to narrow some of its gap with the US and the rest of the world in the second half of this year and the first half of 2022, even if the global manufacturing sector comes off its boil soon. The 2020 recession was unique. In a normal recession, capex, real estate investment, spending on durable goods and the manufacturing sector are the main contributors to the decline in GDP. This time, consumption and the service sector generated most of the contraction in output. These two sectors also caused the second dip in GDP following the tightening of lockdown measures across Europe last winter. Once the more recent wave of lockdowns is behind us, consumption will most likely slingshot to higher levels. More than the US, where the economy has been partially open for months now, Europe remains replete with significant pent-up demand. Obviously, fulfilling this demand will require further progress in the European vaccination campaign, something we recently discussed. Chart 7The Money Supply Forecasts A Rapid Recovery The Money Supply Forecasts A Rapid Recovery The Money Supply Forecasts A Rapid Recovery The surge in M1 also points to a sharp rebound in consumption once governments lift the current lockdowns (Chart 7). M1 is a much more reliable predictor of economic activity in Europe than in the US, because disintermediation is not as prevalent in the Eurozone, where banks account for 72% and 88% of corporate and household credit, respectively, compared to 32% and 29% in the US. We cannot dismiss the explosion in the money supply as only a function of the ECB’s actions. European banks are in much better shape today than they were 10 years ago. Non-performing loans have been steadily decreasing. A rise in delinquencies is likely in the coming quarters due to the pandemic; however, the EUR3 trillion in credit guarantees by governments will limit the damages to the private sector’s and banking system’s balance sheets. Moreover, the Tier-1 capital ratio of the banking system ranges between 14% for Spain and 17% for Germany, well above the 10.5% threshold set by Basel-III (Chart 8). In this context, the pick-up in money supply mirrored credit flows. Thus, even if some of that credit reflects precautionary demand, the likelihood is high that a significant proportion of the built-up cash balances will find its way into the economy. Another positive sign for consumption comes from European confidence surveys. Despite tighter lockdown measures, consumer confidence has sharply rebounded, which historically heralds stronger consumption. Moreover, according to the ECB’s loan survey, stronger consumer confidence is causing an improvement in credit demand, which foreshadows a decline in savings intentions, especially now that wage growth is stabilizing (Chart 9). Nonetheless, there is still a risk that the advance in wages peters off. The recent wage agreement reached by Germany’s IG Metall union in North Rhine Westphalia was a paltry 1.3% annual pay raise, and once the Kurzarbeit programs end, the true level of labor market slack will become evident. However, for consumption to grow, all that we need to see now is stable wage growth, even if at a low rate.  Chart 8European Banks Are Feeling Better European Banks Are Feeling Better European Banks Are Feeling Better Chart 9Confidence Points To Stronger Consumption Confidence Points To Stronger Consumption Confidence Points To Stronger Consumption Beyond consumption, Europe’s fiscal policy will be positive compared to the US next year. The NGEU plan will add roughly 1% to GDP in both 2021 and 2022. As a result, the Eurozone’s net fiscal drag should be no greater than 1% of GDP next year. This compares to a fiscal thrust of -7% in the US in 2022, even after factoring in the new “American Jobs Act” proposed by the Biden Administration last week, according to our US Political Strategy team. Bottom Line: The revival in European consumption in the second half of 2021 and the first half of 2022 will allow the gap between European and global growth to narrow. This dynamic will be reinforced next year, when the fiscal drag will be lower in Europe than in the US. These forces will create a rare occasion when European growth will improve despite a deceleration (albeit a modest one) in global manufacturing activity. Investment Conclusions The continued sensitivity of the euro area economy to the global industrial and trade cycle indicates that over the long-term, European assets will remain beholden to the gyrations of global growth. In other words, the euro and European stocks will outperform in periods of accelerating global manufacturing activity, as they have done over the past 30 years. The next 12 to 18 month may nonetheless defy this bigger picture, allowing European assets to generate alpha for global investors. Chart 10The Euro Will Like Idiosyncratic European Growth The Euro Will Like Idiosyncratic European Growth The Euro Will Like Idiosyncratic European Growth First, the gap between US and euro area growth will narrow over the coming 12 to 18 months, thus the euro will remain well bid, even if the maximum acceleration in global industrial activity lies behind. As investors re-assess their view of European economic activity and the current period of maximum relative pessimism passes, inflows into the euro area will accelerate and the euro will appreciate (Chart 10). Hence, we continue to see the recent phase of weakness in EUR/USD as transitory. Second, European equities have scope to outperform US ones over that window. Some of that anticipated outperformance reflects our positive stance on the euro. However, a consumption-driven economic bounce will be positive for European financials as well. Such a recovery will let investors ratchet down their estimates of credit losses in the financial system. Moreover, banks are well capitalized, thus the ECB will permit the resumption of dividend payments. Under these circumstances, European banks have scope to outperform US ones temporarily, especially since Eurozone banks trade at a 56% discount to their transatlantic rivals on a price-to-book basis. An outperformance of financials will be key for Europe’s performance. Chart 11German/US Spreads Near Equilibrium? German/US Spreads Near Equilibrium? German/US Spreads Near Equilibrium? Finally, we could enter a period of stability in US/German yield spreads over the coming months. The ECB remains steadfast at limiting the upside in European risk-free rates, as Christine Lagarde reiterated last week. However, BCA’s US bond strategist, Ryan Swift, believes US yields will enter a temporary plateau, as the Federal Reserve will not adjust rates until well after the US economy has reached full employment. Hence, the Fed is unlikely to let the OIS curve bring forward the date of the first hike currently priced in for August 2022 on a durable basis, which also limits the upside to US yields. Thus, looking at core CPI and policy rate differences, US yields have reached a temporary equilibrium relative to Germany (Chart 11).   Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com

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

Highlights Duration & The Fed: Unlike the bond market, the Fed is being intentionally cautious about how quickly it revises its interest rate expectations higher, focusing more on hard economic data than on surveys. We expect the Fed dots to move up later this year as the hard economic data improve, validating current pricing in the bond market. Maintain below-benchmark portfolio duration. Yield Curve: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up. Feature The pain in the bond market continues. The 10-year Treasury yield rose again last week, closing at 1.74% on Friday, and the Bloomberg Barclays Treasury Index has now returned -6.1% since it peaked last August. If we use the peak-to-trough drawdown in the Treasury Index as our gauge, we are now in the midst of one of the five worst bond selloffs of the past 50 years. During that 50-year period, the current bearish bond move is only surpassed by the 2009, 2003, 1994 and 1980 episodes (Chart 1). Chart 1A Historic Bond Rout A Historic Bond Rout A Historic Bond Rout That said, the current bond selloff might still have a lot of runway. In level terms, the 30-year Treasury yield has only just recaptured its 2020 peak and the 10-year yield hasn’t even done that (Chart 2). Then, there’s another 101 bps of upside in the 30-year yield and 150 bps of upside in the 10-year yield just to get back to their 2018 peaks, yield levels that aren’t exactly distant memories. Yields do look stretched if we look at long-dated forwards. The 5-year/5-year forward Treasury yield, for example, is already well above its 2020 peak. The large increase in the 5-year/5-year forward yield is the result of Fed policy keeping the short-end of the yield curve capped (Chart 2, bottom 2 panels) forcing the bulk of Treasury weakness to be felt at the long-end. The 5-year/5-year forward Treasury yield is important because it reflects the market’s expectation of where the fed funds rate will settle in the long-run. In fact, you can use survey estimates of the long-run neutral fed funds rate to get a useful fair value range for the 5-year/5-year forward. At present, the 5-year/5-year forward yield has pushed well above this survey-derived fair value range (Chart 3), though it’s important to note that it is still 75 bps below its 2018 peak. Survey estimates of the long-run neutral fed funds rate were revised down as growth disappointed in 2019, it stands to reason that they could be revised higher as growth improves this year, thus moving the fair value range up as well. Chart 2Yields Can Rise Further Yields Can Rise Further Yields Can Rise Further Chart 35-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated 5-Year/5-Year Is Elevated In fact, whether that process of upward revisions to survey estimates of the long-run neutral fed funds rate begins is an important near-term question for the bond market. Upward revisions would signal further upside in long-dated yields and more curve steepening ahead. Static long-run neutral rate estimates would signal that the upside in long-maturity yields is limited. In that latter case, the cyclical bond bear market would transition to a less severe bear-flattening phase where short-maturity yields eventually catch up to the long-end as the Fed tightens policy. It’s currently unclear how those survey estimates will evolve – we will get March updates for both surveys shown in Chart 3 on April 8th – but for now it’s too soon to say that the 5-year/5-year forward yield has peaked. We continue to recommend maintaining below-benchmark portfolio duration as we keep tabs on our Checklist To Increase Portfolio Duration.1 Currently, our Checklist is not screaming out for us to make a change. Explaining The Disagreement Between The Fed And The Market We expected that Fed policymakers would revise up their interest rate forecasts at last week’s FOMC meeting, but we also expected that the forecasts wouldn’t rise far enough to match the rate hike path that is currently priced in the market.2 This is in fact what happened, though the Fed was slightly more dovish than we anticipated. Only 7 out of 18 FOMC participants expect any rate hikes at all before the end of 2023, while the overnight index swap curve is discounting more than four 25 basis point hikes by then (Chart 4). Chart 4Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed What explains this divergence between the market and the Fed? Perhaps bond investors are simply ignoring the Fed’s dovish message. In that case, we should expect yields to fall as it becomes clear that the Fed intends to keep rates pinned at zero for much longer than is currently priced in the curve. Or perhaps Fed policymakers just don’t appreciate the surge in economic activity that is about to unfold. In that case, their interest rate forecasts (the “dots”) will rise sharply in the coming months as the economic data improve. Chair Powell gave a hint about how we should think about the divergence between the market and the “dots” in his post-meeting press conference. He said that the Fed wants to see “actual progress” towards its economic objectives not “forecast[ed] progress”, and he noted that this increased focus on “actual progress” is “a difference from our past approach.”3 In other words, the Fed is making a concerted effort to take a more backward-looking approach to policymaking under its new Average Inflation Targeting regime. It doesn’t want to tighten policy in response to a forecast of stronger growth in the future only to get whipsawed if that forecast doesn’t pan out. It would rather err on the side of tightening too late and then possibly have to move more quickly if it falls behind the curve. The market, by contrast, is a purely forward-looking discounting mechanism. Market prices move quickly to incorporate new information but are often caught offside. We are reminded of Paul Samuelson’s famous quip that the stock market has predicted nine of the past five recessions. This explains exactly what is happening right now. The market is looking ahead, taking its cues from survey data (or “soft data”) such as the ISM indexes that are pointing toward a sharp rise in economic activity and inflation. The Fed, by contrast, is endeavoring to focus more on the actual hard economic data such as the unemployment rate, industrial production and consumer price indexes. These hard economic data simply haven’t improved that much yet. The last section of this report (titled “Economy: Hard Vs Soft Data”) gives some examples of how the hard and soft economic data have diverged. Chart 5The Path Back To Maximum Employment The Path Back To Maximum Employment The Path Back To Maximum Employment Ultimately, the disagreement between the market’s funds rate expectations and the Fed’s dots will be resolved as the hard economic data are released during the next few months. Those data will either validate the current message from economic surveys, causing the Fed to revise up its rate forecasts, or disappoint market expectations, causing market forecasts and bond yields to fall. In this regard, the hard economic data on the labor market will be particularly important. The Fed has said that it will not lift rates until “maximum employment” is achieved. In practice, “maximum employment” means that the unemployment rate will fall into a range of 3.5% - 4.5%, consistent with the Fed’s estimates of the natural rate, and the labor force participation rate will recover to pre-COVID levels (Chart 5). The top row of Table 1 shows that average monthly employment growth of 419k is required to achieve that target by the end of 2022. We have made the case in prior reports that, though that number seems high, it is achievable.4   Table 1Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date The Fed Looks Backward While Markets Look Forward The Fed Looks Backward While Markets Look Forward It’s also worth noting that the Fed’s median unemployment rate forecast was revised significantly lower last week. The Fed is now looking for an unemployment rate of 4.5% by the end of this year and 3.9% by the end of 2022 (Chart 5, top panel). The fact that the Fed doesn’t project any rate hikes during this timeframe can only mean that policymakers aren’t forecasting a similar recovery in the labor force participation rate. The bottom line is that, unlike the market, the Fed is being intentionally cautious about how quickly it revises its funds rate expectations higher, focusing more on hard economic data than surveys. Eventually, the disagreement between the hard and soft economic data will be resolved and either the Fed dots will move toward the market, or the market will move toward the Fed. Our sense is that the Fed is probably being overly cautious and that their forecasts will eventually move toward the market, validating current bond yields. Too Early To Expect Curve Flattening We have been recommending nominal Treasury curve steepeners for some time, on the view that the yield curve will trade directionally with yields. This means that rising yields will coincide with curve steepening.5 This correlation has held up extremely well, but we know that it won’t last forever. Eventually, we will be close enough to Fed rate hikes that the yield curve will start to flatten as yields rise. This process will begin at the long-end of the curve and gradually shift toward the short-end as Fed liftoff approaches. Chart 6 shows how the correlation between the level of Treasury yields and different yield curve slopes has held up during the recent surge in bond yields. For the most part, the tight correlation between rising yields and steeper curves remains intact, with the 10/30 slope being the exception (Chart 6, bottom panel). It looks like during the past month the 10/30 slope has transitioned from a bear-steepening/bull-flattening regime into a bear-flattening/bull-steepening regime. The investment implication is that the short position of a curve steepener trade should be applied to the 10-year note not the 30-year bond, particularly for duration-neutral steepeners. It’s difficult to know exactly when the other segments of the yield curve will transition from their bear-steepening/bull-flattening regimes into bear-flattening/bull-steepening regimes, but we suspect that the current correlations have quite a bit more running room. If we look at what occurred prior to the last time that the Fed lifted rates off the zero bound, in December 2015, we see that most curve segments didn’t start to bear-flatten until a few months before liftoff (Chart 7) Chart 6Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Bear-Steepening/Bull-Flattening Regime Continues Chart 7Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff Bear-Flattening Started Just Months Before 2015 Liftoff In terms of how to implement a yield curve steepener, we have been recommending a position long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. We are sticking with that position for now, as it has performed well even as the 2/5/10 butterfly spread has widened in recent weeks (Chart 8). We expect it will continue to perform well as long as both the 2/5 and 5/10 yield curve slopes continue to steepen. Once we suspect that the 5/10 slope is transitioning into a bear-flattening/bull-steepening regime, we will have to either shift into a curve flattener or a curve steepener that is focused more at the short-end of the curve. Chart 85/10 Slope Still Steepening 5/10 Slope Still Steepening 5/10 Slope Still Steepening Bottom Line: The Treasury yield curve continues to trade directionally with the level of yields, except for the 10/30 slope which has now begun to bear-flatten. Investors should continue to position for curve steepening out to the 10-year maturity point. We recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes. Economy: Hard Vs. Soft Data Chart 9IP Lags The PMI IP Lags The PMI IP Lags The PMI Chart 10Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead Surveys Suggest Higher Inflation Ahead As noted above, the US economy is at an interesting inflection point where, owing to large-scale fiscal stimulus and an effective COVID vaccination rollout, there is a lot of optimism about the future. This optimism is showing up in how people respond to surveys about their economic and business expectations, but it has not yet translated into better actual economic outcomes. The ISM Manufacturing PMI survey is a case in point. It surged to 60.8 in February, its highest level since 2018, but actual measured industrial production continues to contract in year-over-year terms (Chart 9). In all likelihood, this is simply a result of surveys (“soft data”) leading the hard data. A simple linear regression fit between industrial production and the PMI shows that wide negative divergences have a habit of showing up during recessions, only for the gaps to close very quickly in the early stages of the recovery. We see the same dynamic at play in the inflation data. Actual core CPI inflation has not moved up significantly, but surveys indicate that price pressures are rising fast (Chart 10). Bottom Line: The US economy is at an inflection point where survey data indicate a great deal of optimism about the economic recovery, but where those optimistic growth prospects are not yet evident in the hard economic data. This is typical of post-recession environments where survey data move first and then the hard economic data play catch up.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on our Checklist please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20210317.pdf 4 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 1Biden’s Tax Hike Proposals On The Campaign Trail Building Back … The Wall Of Worry Building Back … The Wall Of Worry Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) Building Back … The Wall Of Worry Building Back … The Wall Of Worry For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening Building Back … The Wall Of Worry Building Back … The Wall Of Worry The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark China Policy Overtightening Benchmark China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge Building Back … The Wall Of Worry Building Back … The Wall Of Worry China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China Building Back … The Wall Of Worry Building Back … The Wall Of Worry The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China EU Risk Averse On China EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce Building Back … The Wall Of Worry Building Back … The Wall Of Worry As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry Table 4BGerman State Elections Show Voters’ Leftward Drift Continues Building Back … The Wall Of Worry Building Back … The Wall Of Worry To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling German Party Polling German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Building Back … The Wall Of Worry Building Back … The Wall Of Worry Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Building Back … The Wall Of Worry Building Back … The Wall Of Worry Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.

Highlights The Biden administration will not attempt a major diplomatic “reset” with Russia. The era of engagement is over. Russia faces rising domestic political risk and rising geopolitical risk at the same time. A war in the Baltics is possible but unlikely. Putin has benefited from taking calculated risks and wants to keep the US and Europe divided. The Russian economy is weighed down by structural flaws as well as tight policy. Investors focused on absolute returns should sell Russian assets. For EM-dedicated investors, our Emerging Markets Strategy recommends a neutral allocation to Russian stocks and local currency bonds and an overweight allocation to US dollar-denominated sovereign and corporate debt. Feature “We will not hesitate to raise the cost on Russia.” – US President Joseph R. Biden, State Department, February 4, 2021 The Biden presidency will differ from its predecessors in that there will not be a major attempt to engage Russia at the outset. Previous US presidents sought to reach out to their Russian counterparts to create room for maneuver. This was true of Presidents Reagan, Clinton, Bush, Obama, and Trump. Even Biden has shown a semblance of reengagement by extending an arms reduction pact. But investors should not be misled. The United States and the Democratic Party have shifted their approach to Russia since the failure of the diplomatic “reset” that occurred in 2009-11 and Washington will take a fundamentally more hawkish approach. Russia is not Biden’s top foreign policy focus – that would be Iran and China. But as with China, engagement has given way to Great Power struggle and hence there will not be a grace period before geopolitical tensions re-escalate. Tensions will keep the risk premium elevated for Russia’s currency and assets. The same is true of emerging European markets that get caught up in any US-Russia conflicts. Putin, Biden, And Grand Strategy Understanding US-Russia relations in 2021 requires a brief outline of both the permanent and temporary strategies of the United States and Russia. Russia’s grand strategy over the centuries has focused on establishing a dominant central government, controlling as large of a frontier as possible, and maintaining a high degree of technological sophistication. The nightmare of the Russian elite consists of foreign powers manipulating and weaponizing the country’s extremely diverse peoples and territories against it, reducing the world’s largest nation-state to its historical origin as a geographically indefensible and technologically backward principality. Chart 1Russia's Revival In Perspective Russia's Revival In Perspective Russia's Revival In Perspective Russia can endure long stretches of austerity in order to undermine and outlast rival states in this effort to achieve defensible borders. Russia’s strategy since the rise of President Vladimir Putin has focused on rebuilding the state and military after the collapse of the Soviet Union so as to restore internal security and re-establish political dominance in the former Soviet space (Chart 1). Partial invasions of Georgia and Ukraine and a military buildup along the border with the Baltic states show Russia’s commitment to prevent American or US-allied control of strategic buffer spaces. Expansion of the North Atlantic Treaty Organization (NATO) and the European Union poses an enduring threat to Putin’s strategy. Putin has countered through conventional and nuclear deterrence as well as the use of “hybrid warfare,” trade embargoes, cyberattacks, and disinformation. To preempt challengers within the former Soviet space Russia also maintains a “veto” over geopolitical developments outside that space, as with nuclear proliferation (Iran), civil wars (Syria, Libya), or resource production (OPEC 2.0). The evident flaw in Putin’s strategy is the decay of the economy, the long depreciation of the ruble, and the drop in quality of life and labor force growth. See the macro sections below for a full discussion of these negative trends. Compare the American strategy: America’s grand strategy is to control North America, dominate the oceans, prevent the rise of regional empires, and maintain the leading position in technology and talent. A nightmare for American policymakers would be a collapse of the federal union among the disparate regions and the rise of a secure foreign empire that could supplant the US’s naval preponderance. This is especially true if the rival empire were capable of supplanting US supremacy in technology, since then the US would not even be safe within North America. America’s strategy under the Biden administration is to mitigate internal political divisions through economic growth, maintain its global posture by refurbishing alliances, and reassert its technological primacy by encouraging immigration and trade. The status quo of strong growth and rising polarization has been beneficial for US technology but not for foreign and defense policy (Chart 2). Political polarization has prevented the US from executing a steady long-term strategy for over 30 years. As a result, Russia has partially rebuilt the Soviet sphere of influence and China is constructing a sphere of its own. A few conclusions can be drawn from the above. First, China poses a greater challenge to the US than Russia from a strategic point of view. China is capable of creating a regional empire that can one day challenge the US for technological leadership. Modern Russia must summon all its strength to carve out small pieces of its former empire – it is not a contender for supremacy in technology or in any regions other than its own. Second, however, Russia’s resurgence under Putin poses a secondary challenge to American grand strategy. Russia can undermine US strategy very effectively. The effect today is to aid the rise of China, on which Russia’s economy increasingly depends (Chart 3). Chart 2US Tech Boom Coincided With Disinflation, Polarization US Tech Boom Coincided With Disinflation, Polarization US Tech Boom Coincided With Disinflation, Polarization Chart 3Russia’s Turn To The Far East Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Unlike the US, Russian leadership has not changed over the past year – and Vladimir Putin’s tactics are likely to be consistent. These were underscored by the constitutional revisions approved by popular vote in September 2020. Not only will Putin be eligible to remain president till 2036 but also Russia reaffirmed its willingness to intervene militarily into neighboring regions by asserting its right to defend Russian-speaking peoples everywhere. Finally, Russia ensured there would be no giving away of territories, thus ruling out a solution on Ukraine over Crimea.1 Bottom Line: The US-Russia conflict will continue under the Biden administration, even though Biden’s primary concern will be China. Biden’s Foreign Policy Intentions It is too soon to draw conclusions about Biden’s foreign policy “doctrine” as he has not yet faced any major challenges or taken any major actions. Biden’s first two foreign policy speeches and interim national security strategy guidance establish his foreign policy intentions, which will have to be measured against his administration’s capabilities.2 His chief intentions are to revive the economy and court US allies: First, Biden asserts that every foreign action will be taken with US working families in mind, co-opting Trump’s populism and emphasizing that US international strength rests on internal unity which flows from a strong economy. This goal will largely be met as the administration is already passing a major economic stimulus and is likely to pass a second bill with long-term investments by October. The impact on Russia is mixed but the Biden administration is largely correct that a strong recovery in the US economy and reduction in political polarization will be a major asset in its dealings with Russia and other rivals. Second, Biden asserts that diplomacy will be the essence of his foreign policy. He aims to create or rebuild an alliance of democracies that spans from the UK and European Union to the East Asian democracies. The two goals of economy and diplomacy are connected because Biden envisions the democracies working together to make “historic investments” in technology, setting global standards and rules of trade, and defending against hacking and intellectual property theft. This goal will have mixed success: the EU and US will manage their own trade tensions reasonably well but they will disagree on how to handle Russia and especially China. Biden explicitly sets up this alliance of democracies against autocracies. He calls China the US’s “most serious competitor” but also highlights Russia: “The challenges with Russia may be different than the ones with China, but they’re just as real.”3 Table 1 shows the Biden administration’s notable comments and actions on Russia so far. What is clear is that the US will not seek an extensive new diplomatic engagement with Russia.4 The failure of the Obama administration’s “diplomatic reset” with Russia has disabused the Democratic Party of the notion that strategic patience and outreach are the right approaches to Putin’s regime. The reset and its failure are described in detail in Box 1. Table 1Biden Administration's First 100 Days: Key Statements And Actions On Russia Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Box 1: What Was The US-Russia Diplomatic Reset? What Comes Next? Most American presidents open their foreign policy with overtures to Russia to create space to maneuver, given that Russia is capable of undermining US aims in so many areas. The Barack Obama administration made a notable effort at this in 2009, which was dubbed the “diplomatic reset.” It was a rest because relations had collapsed over Russia’s use of natural gas pipelines as a weapon against Ukraine and especially its invasion of Georgia in 2008. Then Vice President Joe Biden led the reset. President Putin had stepped aside in accordance with constitutional term limits, putting his protégé Dmitri Medvedev in the presidential seat, which supported the reset because Medvedev had at least some desire to reform Russia’s economy. The reset lasted long enough for Washington and Moscow to agree on the need for a strategic settlement on the question of Iran – which would culminate in the 2015 nuclear deal – as well as to admit Russia to the World Trade Organization (WTO). But the aftermath of the financial crisis proved an inauspicious time for a reset. Along with the Arab Spring, popular unrest emerged in Moscow in 2011 and western influence crept into Ukraine – all of it allegedly fomented by Washington. Putin feared he would lose central control at home and frontier control abroad. He also sensed an opportunity given that commodity prices were filling state coffers while the US was focused on domestic policy, increasingly polarized, and unwilling to make the sacrifices necessary to solidify its influence in eastern Europe. Russia’s betrayal of the reset resulted in a string of losses for the US and its European allies: the Edward Snowden affair, the invasion of Ukraine, the intervention in Syria, the meddling in the 2016 US election, and most recently the SolarWinds hack. The Obama administration refrained from a strong reaction over Crimea partly to seal the Iran deal. But Russia pressed its advantage after that. It is doubtful that Russia’s influence decided the 2016 election but, regardless, the Democratic Party fell from power and then watched in dismay as the Trump administration revoked the Iran deal. Now that the Democrats are back in power they will seek to retaliate not only for the SolarWinds hack but also for the betrayal of the reset. However, retaliation will come at a time of Washington’s choosing. Bottom Line: The Biden administration’s foreign policy will emphasize alliances of democracies in opposition to autocracies like Russia and China. Biden is planning a more hawkish approach to Russia than previous recent administrations. Biden’s Foreign Policy Capabilities There are a few clear limitations on Biden’s foreign policy goals. First, his administration will largely be focused on domestic priorities. In foreign affairs there is at best the chance to salvage the Obama administration’s foreign policy legacy. Second, Biden’s dealings with China will take up most of his time and energy. China’s fourteenth five-year plan contains a state-driven technological Great Leap Forward that will frustrate any attempt by Biden to reduce tensions. Biden will not be able to devote much attention to Russia if he pursues China with the attention it deserves, i.e. to secure US interests yet avoid a war.5 Third, Biden will be limited by allied risk aversion and the need for consensus on difficult decisions. If his diplomacy with Europe is successful then China and Russia will face steeper costs for any provocative actions. If it fails then European risk aversion will prevail, the allies will remain divided, and China and Russia will faces few costs for maintaining current policies. Table 2Russia’s Pipeline Export Capacity Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time The Nordstream Two pipeline will be a key test of European willingness to follow the US’s lead even if it means taking on greater risks: Nordstream Two is a major expansion of Russian-EU energy cooperation but contrary to America’s national interest. German Chancellor Angela Merkel still backs the project despite Russia’s poisoning and imprisonment of dissident Alexei Navalny and forceful suppression of protests. However, Merkel is a lame duck and there is some evidence that German commitment to the project is fraying.6 Biden has not tried to halt the pipeline project, but he still could. There are only 100 miles left to the pipeline. Construction resumed in January after a hiatus last year due to US sanctions. The project will take five months to complete at the rate of 0.6 miles per day. The Biden administration still has time to halt the project through sanctions. If it does, the Russians will react harshly to this significant loss of economic and strategic influence over Europe (Table 2). Biden will have a crisis on his hands in Europe. If Biden does nothing on Nordstream, then Russia will conclude that his administration is not serious and take actions that undermine the Biden administration in accordance with Putin’s established strategy. This would prompt Biden to act on his pledge to stand up to Putin’s provocations. Whereas if Biden imposes sanctions to halt Nordstream, Russia will retaliate. Elsewhere it is possible that Biden will be too confrontational with Russia for Europe’s liking. Biden plans to increase support for Ukraine, which will prompt an increase in military conflict this spring.7 The US will promote democracy across eastern Europe, including Belarus, and it is possible that Russia could overreact to this threat of turning peripheral regimes against Russia. The EU is on the front lines in the conflict with Russia and will not want the US to act aggressively – but the US is specifically seeking to “raise the cost” on Russia for its aggression.8 Bottom Line: Russia is not Biden’s priority. But his pledge both to promote democracy and retaliate against Russian provocations sets the US up for a period of higher tensions. US-Russia Engagement On Iran? Will the US not need to engage Russia to achieve various policy goals? Specifically, while highlighting competition, Biden says he will engage Russia and China on global challenges, namely the pandemic, climate change, cybersecurity, and nuclear proliferation. Nuclear proliferation is the only one of these areas where US-Russia cooperation might matter. After all, there is zero chance of cybersecurity cooperation. Whereas on nuclear issues, the US and Russia immediately extended the New START arms reduction treaty through 2026 and could also work together on Iran. Biden is determined to restore the Obama administration’s 2015 nuclear deal. Moscow does not have an interest in a nuclear-armed Iran so there is some overlap of interest. The Iranian issue will require Biden to consider whether he is willing to make major concessions to Russia: Compromise the hard line on Russia: A new Iranian administration takes office in August. Biden is likely to have to rush a return to the 2015 nuclear deal before that time if he wants a deal with Iran. Otherwise it would take years for Biden and the Europeans to reconstitute the P5+1 coalition with Russia and China and negotiate an entirely new deal. Biden would have to make major concessions to Russia and China. His stand against autocracy would be compromised from the get-go. Maintain the hard line on Russia: The alternative is for Biden to rejoin the 2015 nuclear deal with a flick of his wrist, with Iranian President Hassan Rouhani signing off by August. Biden would extract promises from the Iranians to keep talking about a broader deal in future. In this case Biden would not need to give the Russians or Chinese any new concessions. Chart 4China Enforces Iran Sanctions China Enforces Iran Sanctions China Enforces Iran Sanctions The Biden administration will be keen to make sure that Russia does not exploit the US eagerness for a deal with Iran as it did with the original deal in 2014-15. Iran has an individual interest in restoring the deal, which is to gain sanction relief and avoid air strikes. The Europeans have helped Iran keep the deal alive. China is at least officially enforcing sanctions (Chart 4). Russia is also urging a return to the deal and would be isolated if it tried to sabotage the deal. This could happen but it would escalate the conflict between the US and Russia. Otherwise, if a deal is agreed, the US will continue putting pressure on Russia in other areas. Bottom Line: The Biden administration is likely to seal an Iranian nuclear deal without any major concessions to Russia. Tail Risk – A War In The Baltics? It is well established that the Putin regime will use belligerent foreign adventures to distract from domestic woes. Just look at poor opinion polling tends to precede major foreign invasions (Chart 5). With the eruption of social unrest in the wake of COVID-19 and the imprisonment of opposition leader Alexei Navalny, it is entirely possible that Russia will activate this tool again. The implication is a new crisis in Ukraine, a larger Russian military presence in Belarus, or further escalation of hybrid warfare or cyberwar in other areas. What about an invasion of the Baltic states of Latvia, Lithuania, and Estonia? Unlike other hotspots in Russia's periphery this is a perennial "black swan" risk that would equate with a geopolitical earthquake in Europe. A Baltic war is conceivable based on Russia’s geographic proximity, military superiority, and military buildup on the border and in the Kaliningrad exclave. The combined military spending of NATO dwarfs that of Russia but NATO is extremely vulnerable in this far eastern flank (Chart 6). However, Europe would cutoff Russia’s economy and join the US in countermeasures while Russia would be left to occupy hostile countries.9 Chart 5Putin Lashes Out When Popularity Falls Putin Lashes Out When Popularity Falls Putin Lashes Out When Popularity Falls The Baltic states are members of NATO and thus an attack on one is theoretically an attack on all. President Trump ultimately endorsed Article V of the NATO treaty on collective self-defense and President Biden has enthusiastically reaffirmed it. The guarantee is meaningless without greater military support to enforce it, so NATO could try to reinforce its forward presence there. This could provoke Russia to retaliate, likely with measures short of full-scale war. Chart 6Russia Would Be Desperate To Invade Baltics Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Since the wars in Iraq and Afghanistan, US rivals have observed that the American public lacks the willingness to fight small wars. It responded weakly to Russia’s invasion of Crimea and China’s encroachments in the South China Sea and Hong Kong. However, foreign rivals do not know whether the unpredictable US leadership and public are willing to fight a major war. Hence Russia and China are likely to continue to focus on incremental gains and calculated risks rather than frontal challenges. Based on the Biden administration’s moderate political capital (very narrow electoral and legislative control), the US will continue to be divided and distracted. Russia, China, and other powers will test the administration and make an assessment before they attempt any major foreign adventures. The testing period is imminent, however, and thus holds out negative surprises for investors. It is also possible that Biden could make the first move – particularly on Russia, where retaliation for the 2020 SolarWinds hack should be expected. Bottom Line: A full-scale war in the Baltics is possible but unlikely as the Russians have succeeded through calculated risks whereas they face drastic limitations in a major war against the NATO alliance. Growth Weighed Down By Tight Policy We now turn to Russia’s domestic economic conditions. Here, Russia also faces major challenges. Authorities are determined to keep a tight lid on both monetary and fiscal policies. In particular, high domestic borrowing costs and negative fiscal thrust will weigh down domestic demand over the next six-to-12 months. There are three reasons authorities will maintain tight monetary and fiscal policies: First, concerns about high inflation are deeply entrenched among consumers, enterprises, and policymakers. Russian consumers and businesses tend to have higher-than-realized inflation expectations. This is due to the history of high inflation as well as stagflation in Russia. A recent consumer poll reveals that rising prices are the number one concern among households (Table 3). Remarkably, the poll was conducted in August amid the height of the pandemic and high unemployment. This suggests that households do not associate growth slumps with lower inflation but rather fear inflation even amid a major recession (i.e., worry about stagflation). Table 3Fear Of Inflation Prevalent Amongst Consumers’ Expectations Biden And Russia: No Diplomatic "Reset" This Time Biden And Russia: No Diplomatic "Reset" This Time Second, Central Bank of Russia Governor Elvira Nabiullina is one of the most hawkish central bankers in the world. Her early tenure was characterized by the 2014-15 currency crisis and a major inflation spike. To combat structural inflation and bring down persisting high inflation expectations, the central bank has adopted a very hawkish policy stance since 2014. There is no sign that the central bank is about to change its hawkish policy. Specifically, monetary authorities have been syphoning liquidity from the banking system. With relatively tight banking system liquidity and high borrowing costs, private credit growth will fail to accelerate from current levels. Third, the government still projects an austere budget for 2021. The fiscal thrust will be -1.7% of GDP this year (Chart 7). While a moderate spending increase is likely, it will not be sufficient to boost materially domestic demand. There are no signs yet that the fiscal rule10 will be further relaxed, potentially releasing more funds for the government to spend this year. The fiscal rule has become an important gauge of the country’s ability to weather swings in energy prices. In addition to the points listed above, policymakers’ inflation worries stem from the economy’s structural drawbacks: Despite substantial nominal currency depreciation in recent years, Russia runs a current account deficit excluding energy. When a country runs a chronic current account deficit, including periods of major domestic demand recessions and currency devaluations, it is a symptom of a lack of productivity gains. Real incomes grew at a quick pace from the mid-1990s, largely driven by the resource boom in the 2000s. Yet rising real incomes were not complemented by expanding domestic manufacturing capacity to produce consumer and industrial goods. As such, imports of consumer goods and services rose alongside real incomes. Russia has been underinvesting. Gross fixed capital formation excluding resources industries and residential construction has never surpassed 10% of GDP in either nominal or real terms (Chart 8). Chart 7Russia: Fiscal Policy Will Remain Austere In 2021 Russia: Fiscal Policy Will Remain Austere In 2021 Russia: Fiscal Policy Will Remain Austere In 2021 Chart 8Russia: Underinvestment Within Domestic Sectors Russia: Underinvestment Within Domestic Sectors Russia: Underinvestment Within Domestic Sectors Geopolitical tensions with the West have discouraged FDI inflows and hindered Russian companies’ ability to raise capital externally. This has inhibited capital spending and ”know-how” transfer and, hence, bodes ill for productivity gains. Russian domestic industries are highly concentrated and, in some cases, oligopolistic in nature. This allows incumbents to raise prices. The number of registered private enterprises has fallen below early 2000s levels (Chart 9). Despite chronic currency depreciation, Russian resource companies have failed to grab a large share of their respective export markets. For instance, Russia’s oil market share of total global oil production has been flat for over a decade and the nation has been losing market share in the global natural gas industry. A shrinking labor force due to poor demographics and meager immigration complements Russia’s sluggish productivity growth and caps its potential GDP growth (Chart 10). Chart 9Russia: Increasing Industry Concentration Russia: Increasing Industry Concentration Russia: Increasing Industry Concentration Some positive signs are appearing in the form of import substitution. Since the Ukraine conflict in 2014 and the resulting Western sanctions, the government has enacted various laws and decrees to incentivize domestic production, and with it providing substitutions for imported goods. Their impact is noticeable in certain sectors. Chart 10Russia: Poor Potential Growth Outlook Russia: Poor Potential Growth Outlook Russia: Poor Potential Growth Outlook In particular, the country has invested heavily in the food industry, as food imports are 16% of overall imports. Agricultural sector output has been rising while imports of key food categories have declined. Recent decrees on industrial goods will likely boost domestic production of some goods and processed resources. Around 40% of Russian imports are concentrated in machinery, industrial equipment, transportation parts, and vehicles. Hence, raising competitiveness in production of industrial goods is essential for Russia to reduce reliance on imports. In short, fewer imports of goods for domestic consumption will make inflation less sensitive to fluctuations in the exchange rate. The current trend is mildly positive, but its pace remains slow. Bottom Line: Russia needs to raise its productivity and labor force growth and, hence, potential GDP growth to deliver reasonable high-income growth without raising inflation. The Cyclical OutLook: Worry About Growth, Not Inflation Cyclically, high domestic borrowing costs and lackluster fiscal spending will weigh down domestic growth and cap inflation for the next 12 months. Russia’s real borrowing costs are among the highest in the EM space. High borrowing costs are causing notable financial stress amongst corporate and household debtors. Commercial banks’ NPLs and provisions are high and rising (Chart 11). Unwilling to take on more credit risk, banks have shunned traditional lending and have instead expanded their assets into financial securities. This trend will likely persist and corporate and consumer credit will fail to boost investment and consumption. The recent pickup in inflation was primarily due to rising food prices and the previous currency depreciation pass-through. Chart 12 illustrates the recent currency appreciation heralds a rollover in core inflation. Chart 11Russia: High Borrowing Costs Are Leading To Higher Credit Stress Russia: High Borrowing Costs Are Leading To Higher Credit Stress Russia: High Borrowing Costs Are Leading To Higher Credit Stress Chart 12Russia: Inflation Will Rollover Due To Stable RUB Russia: Inflation Will Rollover Due To Stable RUB Russia: Inflation Will Rollover Due To Stable RUB In fact, a broad range of inflation indicators suggest that core inflation remains within the central bank target (Chart 13). These measures of inflation are less correlated with the ruble movements. Chart 13Russia: Inflation Is At Central Bank Target Of 4% Russia: Inflation Is At Central Bank Target Of 4% Russia: Inflation Is At Central Bank Target Of 4% Chart 14Russia: Tame Recovery In Domestic Activity Russia: Tame Recovery In Domestic Activity Russia: Tame Recovery In Domestic Activity High-frequency data suggest that consumer spending and business activity remain tame (Chart 14). Bottom Line: The latest uptick in Russia’s core CPI is likely transitory. Cyclical conditions for a material rise in inflation and hence monetary tightening are not in place. Investment Takeaways Chart 15Russia Underperforms Amid Commodity Bull Run Russia Underperforms Amid Commodity Bull Run Russia Underperforms Amid Commodity Bull Run Russia’s sluggish economy and austere policy backdrop suggest that the fires of domestic political unrest will continue to burn. While political instability may force the Kremlin to ease fiscal policy, the easing so far envisioned is slight. The implication is that Russia faces rising domestic political risk simultaneously with the rise in international, geopolitical risk stemming from the Biden administration’s efforts to promote democracy in Russia’s periphery and push back against its regional and global attempts to undermine the US-led global order. So far the totality of Russia’s risks have outweighed the benefits of the global economic recovery as Russian assets are trailing the rally in commodity prices (Chart 15). The ruble is above the lows reached at the height of the Ukraine crisis, whether compared to the GBP or the EUR, suggesting further downside when US-Russia tensions spike (Chart 16). The currency is neither cheap nor expensive at present (Chart 17). Chart 16Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Ruble Will Fall Further On Geopolitical Risk But Floor Not Far Chart 17Russia: The Ruble Is Fairly Valued Russia: The Ruble Is Fairly Valued Russia: The Ruble Is Fairly Valued   Chart 18Geopolitical Risk Will Revive Despite Apparent Top Geopolitical Risk Will Revive Despite Apparent Top Geopolitical Risk Will Revive Despite Apparent Top Our Geopolitical Risk Indicator for Russia is forming a bottom, implying that global investors believe the worst has passed. This is a mistake and we expect the indicator to change course and price in new risk. The result will weigh on Russian equities, which are fairly well correlated with this indicator (Chart 18). Overall, we recommend investors who care about absolute returns to sell Russian assets. For dedicated EM equity as well as EM local currency bond portfolios, BCA's Emerging Markets Strategy recommends a neutral stance on Russia (Chart 19). Rising bond yields in the US will continue weighing especially on high-flying growth stocks. The low market-cap weight of technology/growth stocks in the Russian bourse makes the latter less vulnerable to rising global bond yields. Concerning local rates, we see value in 10-year swap rates, as tight monetary and fiscal policies will keep a lid on inflation. With the central bank unlikely to hike rates anytime soon, a steep yield curve offers good value in the long end of the curve for fixed income investors. Finally, orthodox macro policies will benefit fixed-income investors on the margin. In regard to EM credit (USD bonds) portfolio, the Emerging Markets Strategy team recommends overweighting Russia (Chart 20). The government has little local currency debt and minimal US dollar debt. Not surprisingly, Russia has been a low-beta credit market and it will outperform its EM peers in a broad sell off. Chart 19Russia: Move To Neutral Local Currency Bond Allocation Russia: Move To Neutral Local Currency Bond Allocation Russia: Move To Neutral Local Currency Bond Allocation Lastly, the Emerging Markets Strategy is moving Ukrainian local currency government bonds to underweight and closing the 5-year local currency bond position. Risks of military confrontation on the Ukraine front have escalated. Chart 20Russia: Remain Overweight On USD Credit Russia: Remain Overweight On USD Credit Russia: Remain Overweight On USD Credit     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Andrija Vesic Associate Editor Emerging Markets Strategy AndrijaV@bcaresearch.com   Footnotes 1 See Pavlo Limkin et al, “Putin’s new constitution spells out modern Russia’s imperial ambitions,” Atlantic Council, September 10, 2020, atlanticcouncil.org. 2 See White House, “Remarks by President Biden on America’s Place in the World,” February 4, 2021, and “Remarks by President Biden at the 2021 Virtual Munich Security Conference,” February 19, 2021, whitehouse.org. 3 See “Remarks … at the … Munich Security Conference” in footnote 2 above. 4 We first outlined this US-Russia disengagement in our last joint special report on Russia, “US-Russia: No Reverse Kissinger (Yet),” July 3, 2020, bcaresearch.com. 5 See Margarita Assenova, “Clouds Darkening Over Nord Stream Two Pipeline,” Jamestown Foundation, February 1, 2021, Jamestown.org. 6 Biden’s “Interim National Security Strategic Guidance,” White House, March 3, 2021, whitehouse.org, reinforces this point by focusing most of its attention on China and largely neglecting Russia. 7 See “Kremlin concerned about rising tensions in Donbass,” Tass, March 4, 2021, tass.com. 8 One way in which this could transpire would be a carbon border tax. The EU says imposing a tariff on carbon-intensive imports will proceed unilaterally if there is not a UN agreement in November because it is a “matter of survival” for its industry as it raises green regulation. The Biden administration also promised in its campaign to levy a “carbon adjustment fee.” Russia, which is exposed as a fossil fuel exporter that does not have a carbon pricing scheme, says such a fee would go against WTO rules. See Kate Abnett, “EU sees carbon border levy as ‘matter of survival’ for industry,” Reuters, January 18, 2021, reuters.com; Sam Morgan, “Moscow cries foul over EU’s planned carbon border tax,” Euractiv, July 27, 2020, euractiv.com. 9 See Heinrich Brauss and Dr. András Rácz, “Russia’s Strategic Interests and Actions in the Baltic Region,” German Council on Foreign Relations, DGAP Report, January 7, 2021, dgap.org; Christopher S. Chivvis et al, “NATO’s Northeastern Flank: Emerging Opportunities for Engagement,” Rand Corporation, 2017. 10 The rule stipulates that a portion of oil and gas revenues that the government can spend is determined by a fixed oil price benchmark. Currently, the benchmark oil price stands at $42 per barrel. The fiscal rule also encompasses constraints on the National Welfare Fund withdrawals in oil prices below $42 per barrel.

Highlights There is too much euphoria and complacency in global markets. The main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. Yet, it does not mean that the bull market will continue uninterrupted. This rally might be short circuited by gravitational forces as happened with the S&P 500 in 1987 and Chinese onshore stocks in 2015. Investors should consider going long EM equity or EM currency volatility to hedge their exposure. Feature There is growing evidence that the global equity rally has turned into a frenzy. Signs of investor euphoria include: The number of traded call options in the US equity market has surged to an all-time high (Chart 1). The number of put options has spiked only in the past couple of weeks and remains well below the number of call options. Chart 1A Call Buying Frenzy Is A Symptom Of Investor Exuberance A Call Buying Frenzy Is A Symptom Of Investor Exuberance A Call Buying Frenzy Is A Symptom Of Investor Exuberance Critically, there is currently too much complacency: the US put-call ratio is as low as it was in 2000 (Chart 2). The volume of stocks traded on and off all US stock exchanges has exploded since late October, reaching an all-time high (Chart 3). Chart 2A Sign Of Equity Market Complacency A Sign Of Equity Market Complacency A Sign Of Equity Market Complacency Chart 3US Equity Trading Volumes Are At All-Time Highs bca.ems_wr_2021_02_04_c3 bca.ems_wr_2021_02_04_c3 Chart 4Retail Investors Haven Been A Powerful Force In Korea And Taiwan Retail Investors Haven Been A Powerful Force In Korea And Taiwan Retail Investors Haven Been A Powerful Force In Korea And Taiwan Equity fervor is prevalent not only among American individual investors but also in many parts of the world. For instance, the breathtaking rallies in the KOSPI and Taiwanese stocks has been primarily driven by local retail investors, as shown in Chart 4. The surge in Taiwanese share prices is stunning because it completely ignores the escalating geopolitical tensions over Taiwan. BCA Research’s Chief Geopolitical Strategist, Matt Gertken, recently argued that while China is unlikely to invade Taiwan immediately, a military stand-off cannot be ruled out. China and the US have yet to arrive at a mutual understanding regarding China’s access to computer chips made in Taiwan. Overall, since the lockdowns in March last year, individual investors have rushed into equities in many countries such as the US, Korea, Taiwan, Japan, India and Brazil, to name a few. Finally, US institutional investors are fully invested, as shown in Chart 5. Besides, Chart 6 reveals that US-domiciled EM equity mutual funds’ liquidity ratio (cash as a percentage of assets) is very low. Chart 5US Institutional Investors Are Long Stocks US Institutional Investors Are Long Stocks US Institutional Investors Are Long Stocks Chart 6US-Domiciled EM Mutual Funds' Cash Is Low US-Domiciled EM Mutual Funds' Cash Is Low US-Domiciled EM Mutual Funds' Cash Is Low   There have been doubts within the global investment community about the potential for small individual investors to move the needle in the overall market. We believe that their impact has been substantial: First, there is plenty of anecdotal evidence to suggest that individual traders have been involved in options trading since the pandemic erupted. By purchasing call options, retail investors exert substantial upward pressure on share prices: dealers – who sell/write call options – typically hedge their risks by acquiring and holding the underlying stock for the duration of respective options. In short, by putting even small amounts of money at work to purchase call options, individual traders meaningfully affect share prices. Second, price formation in financial markets is influenced by the marginal investor. Everything else being equal, the entry of a new buyer into the marketplace leads to higher prices. Further, retail investors’ impact on financial markets has not been limited solely to stocks they purchase. Rather, there has been a ripple effect on the broader market. For instance, there is evidence that individual investors flocked to the market in March and April and bought en masse shares of companies most negatively affected by the pandemic, such as cruise operations, hotels, airlines and energy producers. As individual investors provided substantial bids for these stocks, institutional investors were able to offload these stocks and buy others. For instance, in Q2 last year Warren Buffett offloaded his airline stocks and allocated that capital to natural gas storage and pipelines, banks, pharma and auto stocks. If retail investors had not provided support to stocks of companies hit hard by the lockdowns and social distancing, Warren Buffett and other professional investors would not have had the opportunity to exit their positions in these stocks at acceptable prices and acquire other securities. This is the mechanism whereby the impact of new market entrants extends beyond the specific equities they purchase. Chart 7A Mini Call Option Mania Among Retail Investors A Mini Call Option Mania Among Retail Investors A Mini Call Option Mania Among Retail Investors Finally, Charts 1 and 3 above clearly illustrate the surge in both the number of call options and trading volumes since last March. Among call options, transactions with a small number of options have ballooned (Chart 7). This reflects individual investors activity. Consistently, the number of brokerage accounts for retail investors has mushroomed in the US and elsewhere. Bottom Line: It is obvious that the ongoing equity market euphoria is considerable. Individual investors have been playing a vital role in fostering it. The GameStop stock saga, among others, reinforces this point. When And How Will It End? This bull market shares some similarities with previous market cycles, but it also has its distinct features. Similarities: Retail investors typically rush into financial markets toward the end of a bull market. The current US equity market rally began in 2009. After the S&P 500 showed its resilience by rebounding quickly and making new highs following the selloffs in 2015, 2018 and 2019, retail investors were reassured to jump on the bull market train when the 2020 crash occurred.  In short, it took about 11 years of a US equity bull run for individual investors to feel comfortable enough to play the stock market. This is a characteristic of a late cycle/mature bull market. Speculative instruments and schemes are designed and launched. The IPO boom in SPACs1 will probably go down in history as a key feature of the speculative excesses in this cycle. Valuations overshoot during stock market euphoria but investors find reasons to justify lofty equity multiples. FAANGM stocks and other parts of the US equity market are expensive, but investors are using extremely low US bond yields – artificially suppressed by the Federal Reserve – to justify the current multiples. In such a case, the bond market will likely hold equities hostage. As bond yields rise going forward, equity valuations will be threatened. In fact, we believe rising bond yields, not the outlook for economic growth, to be the primary risk to US share prices akin to the late 1960s (Chart 8). Differences: Typically, retail investors feel comfortable investing in the stock market when the economy is strong. In this cycle, they jumped on the stock market train when the economy crashed due to the pandemic. This is a departure from previous cycles. Massive stimulus and ongoing vaccination deployment suggest the economic outlook for the US and many emerging economies is positive. In particular, EM corporate profits are set to recover (Chart 9). Chart 8The US In The 1960s: Share Prices And Treasury Yields The US In The 1960s: Share Prices And Treasury Yields The US In The 1960s: Share Prices And Treasury Yields Chart 9EM EPS Is To Recover EM EPS Is To Recover EM EPS Is To Recover   Hence, it is hard to be bearish on stocks based on the cyclical outlook for growth, assuming vaccination campaigns will allow many major economies to fully reopen in H2 2021. Yet, a lot of this good news seem to be already priced in. Retail investors arrive to the stock market party usually in the late stage of a business cycle – when unemployment is low, inflation is rising, and policymakers are tightening policies. That combination proves lethal for the equity market and a major top in share prices ensues. Presently, due to the pandemic-induced lockdowns, we have the opposite occurring in the US and in many EM economies. Unemployment is high, inflation remains contained, and policymakers are committed to providing unlimited stimulus. In short, the main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. History doesn't repeat itself, but it does rhyme. Does it mean that the bull market will continue uninterrupted? Not necessarily. This rally might be short circuited for reasons that may differ from those that terminated previous stock market frenzies. First, speculative bubbles could burst without policy tightening. An example of this is China’s equity bubble in 2015, which crashed without policy tightening due to gravitational forces reasserting themselves. Another example is the 1987 US stock market crash that occurred without an economic or fundamental financial cause. Chart 10 illustrates the cyclical trajectories of US GDP and the Fed funds rate did not change materially before and after the equity market crash. In short, the 1987 equity crash was a case when excessive speculation/overbought conditions rather than policy tightening or a recession caused an abrupt equity sell-off. Second, in the EM equity universe, leadership has been extremely narrow. Only a handful of companies have outperformed the aggregate benchmark, propelling the index to 2007 highs. These include a few Chinese new economy stocks, and Korean and Taiwanese technology stocks (Chart 11). Outside North Asian markets (China, Korea and Taiwan), every single EM bourse has underperformed both the EM and global equity benchmarks in the past year. Chart 10The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy Chart 11Euphoria In Asian TMT Stocks Euphoria in Asian TMT Stocks Euphoria in Asian TMT Stocks Chart 12Global ex-TMT Stocks Have Not Broken Out Yet bca.ems_wr_2021_02_04_c12 bca.ems_wr_2021_02_04_c12 If these global and EM TMT stocks relapse, they will inflict major damage on the EM and global indexes. The EM index has become extremely concentrated with the top five stocks accounting for 24% of the MSCI EM equity index’s market cap. Interestingly, global ex-TMT stocks have not yet broken out to new highs (Chart 12). Finally, US overall equity and global TMT valuations are vulnerable to rising US bond yields. The latter could rise without the Fed hinting at policy tightening if fixed-income investors decide that the Fed is behind the inflation curve. This could trigger a major selloff even if policymakers do not tighten policy. Investment Conclusions Chart 13Go Long EM Equity And Currency Volatility Go Long EM Equity And Currency Volatility Go Long EM Equity And Currency Volatility We are in a euphoria phase where fundamentals are less pertinent. The market can either rally a lot or sell off hard regardless of the profit outlook. Navigating through such markets is challenging. Going long EM equity or EM currency volatility offers a good risk-reward profile (Chart 13). Volatility will likely rise in the coming months in both scenarios: either risk assets continue rallying or they sell off. For global equity and credit portfolios, we continue recommending a neutral allocation to EM. The long-term US dollar outlook is negative, but it is oversold and odds of a near-term rebound are still high. Our currency strategy remains to short a basket of EM currencies versus an equal-weighted average of the euro, CHF and JPY. This basket of EM currencies includes the BRL, CLP, ZAR, KRW and TRY. We continue receiving 10-year swap rates in Mexico, Colombia, Russia, China, India, Indonesia and Korea. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Special Purpose Acquisition Companies (SPAC), also known as “blank check companies”, are organizations with no commercial operations that raise capital through an IPO, which is then deployed to purchase an existing company. This process is done to bypass the lengthy process of launching a traditional IPO for a young company.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues Chinas Economic Recovery Continues Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese Stocks: Which Way Will The Winds Blow? Chinese Stocks: Which Way Will The Winds Blow? Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Too Much Growth Priced In Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. 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 observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Credit Impulse Has Peaked... Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Rising Deflation Risks Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales ...And Promote NEV Sales ...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations

  Chart Of The WeekInvestor Consensus Is Bearish On Dollar Investor Consensus Is Bearish On Dollar Investor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets.   The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively.  In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well US Equities Have Been Trading Well US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well US Equities Have Been Trading Well US Equities Have Been Trading Well   Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM Equity Market Breadth Is Strong In The US But Poor In EM Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving The World Economy And Global Trade Are Reviving The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The World Economy And Global Trade Are Reviving The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted The US: Cash On The Sidelines Has Declined But Is Not Exhausted The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted The US: Cash On The Sidelines Has Declined But Is Not Exhausted The US: Cash On The Sidelines Has Declined But Is Not Exhausted   A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy   The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering The Business Cycle In China Is Recovering The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering The Business Cycle In China Is Recovering The Business Cycle In China Is Recovering   China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy China: The Stimulus Is Working Its Way Into The Economy China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy China: The Stimulus Is Working Its Way Into The Economy China: The Stimulus Is Working Its Way Into The Economy   China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth   China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? China: From Commodities Restocking To Destocking? China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking? China: From Commodities Restocking To Destocking? China: From Commodities Restocking To Destocking?   Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Red Flags For EM Currencies Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities Yellow Flags For EM Equities Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Many Currencies Against The US Dollar Are At Critical Resistances Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances Many Currencies Against The US Dollar Are At Critical Resistances Many Currencies Against The US Dollar Are At Critical Resistances   Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Are Global Defensive Equity Sectors On A Cusp Of Outperformance?   These Markets Have Not Yet Entered A Bull Market  These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market These Markets Have Not Yet Entered A Bull Market These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market These Markets Have Not Yet Entered A Bull Market These Markets Have Not Yet Entered A Bull Market   Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Risk Measures Signal Modest Investor Complacency Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency Risk Measures Signal Modest Investor Complacency Risk Measures Signal Modest Investor Complacency   EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights When it comes to a beauty contest among currencies, the US dollar is a winner right now. Significant dollar moves tend to occur in very long cycles. When – and only when – the crisis ends will the dollar begin to surrender to significant headwinds. The transition from a stronger to weaker dollar is likely to occur in fits and starts. Watch the gold-to-bond ratio and USD/CNY exchange rate as key arbiters in timing this shift. Feature The world economy has clearly been nudged into a very deep recession. But as with other pandemics, the global economy is likely to survive this one too. As currency markets continue to fight a tug-of-war between deteriorating global growth and very easy financial conditions, it is instructive to start placing bets on the likely winners (and losers) that will emerge from this battle. Throughout the past few decades, the most powerful driver of currencies has been the relative rate of return between any two economies. After all, an exchange rate is simply a measure of relative prices between any two concerns. And as equilibrating mechanisms by definition, currencies will fluctuate to equalize rates of returns across borders. Therefore, placing bets with higher odds of success critically requires answering two questions. Which markets and/or asset classes have the highest potential rate of return? What are the key mechanisms/signals through which this value will be unlocked? The Source Of US Dollar Beauty When it comes to a beauty contest among currencies, the US dollar is clearly the fairest. In fact, the most recent Treasury International Capital (TIC) data show that inflows into US assets have been reaccelerating (Chart I-1). Remarkably, the momentum of these purchases has been driven by equities (bottom panel), as US stocks have outperformed their international peers. Even the 2017 change in the US tax code to allow for favorable capital repatriation still continues to benefit the dollar. On a rolling 12-month basis, the US has repatriated about $192 billion in net assets, or close to 1% of GDP. Chart I-11. Inflows Into US Assets Are Picking Up 1. Inflows Into US Assets Are Picking Up 1. Inflows Into US Assets Are Picking Up Supercharging this trend has been a global shortage of dollars, which has increased the international appeal of US paper. This was triggered by the Federal Reserve’s tapering of asset purchases. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and, until recently, had been falling. This triggered a severe contraction in the U.S. monetary base (Chart I-2), and curtailing commercial banks’ excess reserves. Chart I-2A Liquidity Flush 2. A Liquidity Flush 2. A Liquidity Flush Despite the Fed’s massive liquidity injections and significant uptake of its swap program (Chart I-3), the greenback could remain well bid in the near term. We will not revisit the analysis here, but encourage clients to read our issue from last week in case they missed it.1 What we can add is that the dollar tends to thrive in uncertainty, and even with ample dollar liquidity, non-banks are still facing dollar shortages. For example, there remains a gap between the rate on the Fed’s US dollar swap lines and various measures of offshore dollar funding. Meanwhile, cross-currency basis swaps are still wide for some developed and emerging market currencies (Chart I-4).2 Chart I-3Foreign Central Banks Tap Into USD Swaps Foreign Central Banks Tap Into USD Swaps Foreign Central Banks Tap Into USD Swaps Chart I-4The Funding Crisis Has Eased The Funding Crisis Has Eased The Funding Crisis Has Eased Bottom Line: As a countercyclical currency, the greenback remains well bid in the near term. Historically, the dollar has tended to move in long cycles, usually 10 years, suggesting the current bull market might be nearing an end (please see Chart I-8 in the next section). This also suggests there is no need to rush into building USD shorts, should the next cycle in the dollar last a decade.  Regime Shift? When, and only when the crisis ends will the dollar begin to surrender to significant headwinds. The good news is that these headwinds continue to mount, and will eventually exert a powerful deflationary force on the greenback.  When, and only when the crisis ends will the dollar begin to surrender to significant headwinds. Starting with equity markets, expected relative returns are extremely unfavorable for US stocks. Chart I-5A – Chart I-5R shows that the equity valuation starting point is important for local-currency returns over the long term. The chart shows 10-year annualized equity relative returns, superimposed on our composite valuation indicator.3 So, in the case of the US versus Japan, the left-hand side scale shows that US equities are trading 1.5 standard deviations above their mean valuation relative to Japanese equities. The right-hand side scale shows what to expect in terms of relative returns over the next 10 years by overweighting Japanese equities relative to the US. Chart I-5A Cycles And The US Dollar Cycles And The US Dollar Chart I-5B Cycles And The US Dollar Cycles And The US Dollar Chart I-5C Cycles And The US Dollar Cycles And The US Dollar Chart I-5D Cycles And The US Dollar Cycles And The US Dollar Chart I-5E Cycles And The US Dollar Cycles And The US Dollar Chart I-5F Cycles And The US Dollar Cycles And The US Dollar Chart I-5G Cycles And The US Dollar Cycles And The US Dollar Chart I-5H Cycles And The US Dollar Cycles And The US Dollar Chart I-5I Cycles And The US Dollar Cycles And The US Dollar Chart I-5J Cycles And The US Dollar Cycles And The US Dollar Chart I-5K Cycles And The US Dollar Cycles And The US Dollar Chart I-5L Cycles And The US Dollar Cycles And The US Dollar Chart I-5M Cycles And The US Dollar Cycles And The US Dollar Chart I-5N Cycles And The US Dollar Cycles And The US Dollar Chart I-5O Cycles And The US Dollar Cycles And The US Dollar Chart I-5P Cycles And The US Dollar Cycles And The US Dollar Chart I-5Q Cycles And The US Dollar Cycles And The US Dollar Chart I-5R Cycles And The US Dollar Cycles And The US Dollar Cycles And The US Dollar Cycles And The US Dollar The forward P/E on MSCI US and Japan is 19.7x and 13.4x, respectively. The skew towards the US is because market participants expect US profits to keep outperforming, the greenback to keep appreciating, or a combination of the two. While this might be plausible in the short term as the fascination with FAANG stocks continues to capture investors’ imaginations, the empirical evidence is that current US valuations have more than fully capitalized future earning streams. Based on historical correlations, expected 10-year annualized returns for the MSCI US relative to Japan is -10%. Importantly, our composite valuation indicator adjusts for sector weights, so that there is no over representation of any sector in any country. So even if technology and healthcare are winners over the next decade, capital can still gravitate from the US towards other markets where these sectors are cheaper. Capital outflows will lead to a selloff in an overvalued US dollar. In fact, across our sample of 18 developed and emerging market currencies, the message remains that long-term equity capital will dry up for US assets due to expensive valuations. Therefore, the latest inflows into US equities are at risk of a Minsky moment. Such capitulation could well be the beginning of a 10-year cycle of dollar weakness. Cross-currency basis swaps are still wide for some developed and emerging market currencies. Second, the US has lost its interest rate advantage. Against an aggregate of G10 currencies, the dollar currently yields almost nil in real terms (Chart I-6). This has historically led to a softer dollar. Remarkably, even for a Japanese or German investor, negative domestic rates might no longer be a catalyst to invest in US paper, should domestic inflation continue blasting downward. The catalyst for outflows could be if the US 10-year Treasury yield hits zero, amidst the Fed adopting negative rates. Chart I-6The US Interest Rate Gap Has Vanished The US Interest Rate Gap Has Vanished The US Interest Rate Gap Has Vanished Chart I-710-Year Cycle Outlook For The Dollar 10-Year Cycle Outlook For The Dollar 10-Year Cycle Outlook For The Dollar Once that happens, new bond investors face the prospect of real losses from either higher yields and/or currency depreciation as the Fed continues to dilute existing Treasury shareholders (Chart I-7). If the Fed is set to anchor the price of money near zero for the foreseeable future, currency depreciation is the only mechanism to entice foreign investors to keep funding the US twin deficits. The US dollar does have an exorbitant privilege in that as a reserve currency, the trade deficit is settled in dollars. However, that privilege does require that the rise in foreign exchange reserves from other central banks are reinvested back into Treasurys. This allows the current account deficit (or capital account surplus) to finance the budget deficit. The bad news is that official flows into US paper have plateaued, with the likes of Beijing and other central banks continuing to destock their holdings of Treasurys (Chart I-8). Global allocation of foreign exchange reserves paints a similar picture – allocations toward the US dollar recently peaked at about 65% and have been in a downtrend since, with the void being filled by other currencies, notably gold, the British pound, the Swiss franc, and the yen. Chart I-8Diversification Away From Dollars Accelerates Diversification Away From Dollars Accelerates Diversification Away From Dollars Accelerates The key point is that for one reason or another, foreign central banks are diversifying out of dollars. Our bias is that China has been doing so to make room for the internationalization of the RMB, as well as for geopolitical reasons, similar to other countries such as Russia. This trend will be supercharged as private investors start to focus on the real prospect of very dire returns over the coming cycle. Bottom Line: Expensive valuations and low interest rates make prospective returns for US equities and fixed income unattractive. This will force private capital to require a much lower exchange rate to fund US liabilities. The RMB And Gold As Umpires Chart I-9Will TLT Outperform GLD Next Decade? Will TLT Outperform GLD Next Decade? Will TLT Outperform GLD Next Decade? The transition from a stronger to weaker dollar is likely to occur in fits and starts. For one, the dollar is a countercyclical currency and will remain strong as uncertainty continues to dominate the macro landscape. We are watching two key indicators (among many others) as signposts for when the shift is occurring: Gold-To-Bond Ratio: One of our favorite indicators for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the breakdown of the Bretton Woods system, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flows of investor confidence in the greenback tick-for-tick. Any sign that the balance of forces are moving away from the US dollar will favor a breakout in the gold-to-bond ratio. The TLT ETF relative to the GLD ETF broke above parity earlier this year, and has since been consolidating those gains (Chart I-9). This has brought it back within the trading range in place since early 2017. A decisive move below 0.95 will be a bearish development for the greenback. RMB Exchange Rate: As the RMB continues to gain international recognition, Chinese government bonds should outperform Treasurys. It is remarkable that from 2011 up until the Fed turned dovish in 2018, Chinese government bond performance was much better than Treasurys, even as the dollar was soaring (Chart I-10). Going forward, the USD/CNY rate should continue to act a key anchor for the direction of cyclical/emerging market currencies, as we highlighted last week. A break above last year’s highs will be bearish, while it will be encouraging if the 7.0 level is breached on the downside. Chart I-10Will Treasurys Outperform RMB Bonds Next Decade? Will Treasurys Outperform RMB Bonds Next Decade? Will Treasurys Outperform RMB Bonds Next Decade? Bottom Line: Watch the bond-to-gold ratio and Chinese RMB exchange rate as key signals for the direction of the US dollar. A breakdown in the US dollar will be a key mechanism to unlock value in foreign assets.  Housekeeping Chart I-11Target 1.10 On AUD/NZD Target 1.10 On AUD/NZD Target 1.10 On AUD/NZD The Reserve Bank of New Zealand decided to keep rates on hold, but reinforced forward guidance by almost doubling the size of its asset purchases to NZ$60 billion, while keeping open the possibility of negative rates. This has driven the divergence between Aussie and Kiwi 10-year yields to the highest level since 2008 (Chart I-11). In a world where rates continue to fall to very low levels, the policy of yield curve control implemented by the Reserve Bank of Australia does not pack the same punch as negative interest rates. Fundamentally, three factors will support the AUD/NZD cross: First, terms-of-trade dynamics are more favorable for Australia, which is lifting the nation’s basic balance to a substantial surplus. While infrastructure investment growth in China is likely to slow from historical levels, liquefied natural gas imports should remain in a structural uptrend. China’s switch from coal to natural gas electricity generation will continue to buffet Australian export volumes. On the kiwi side of things, as food security becomes more and more important in a post COVID-19 world, agricultural exports will not enjoy the same volume boost. Stay long AUD/NZD. Second, a substantial lift to New Zealand’s labor dividend has come from immigration (Chart I-12). The recent surge in net migrant numbers is due to exit restrictions for recent entrants. Yet even as things return to normal, that labor dividend will remain low as many people rethink international travel for work. This will restrain some supply-side parts of the economy, prompting the RBNZ to keep rates lower for longer. Chart I-12Loss Of A Meaningful Tailwind For Employment Loss Of A Meaningful Tailwind For Employment Loss Of A Meaningful Tailwind For Employment Finally, the cross offers a lot of relative value – not just from an interest rate standpoint, but also on a real effective exchange rate basis.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Line In The Sand,” dated May 08, 2020, available at fes.bcaresearch.com. 2 Egemen Eren, Andreas Schrimpf, and Vladyslav Sushko, “US Dollar Funding Markets During The Covid-19 Crisis – The International Dimension,” BIS Bulletin (May 12, 2020). 3 Composite indicator comprised of price-to-earnings, forward price-to-earnings, price-to-cash flow, dividend yield, price-to-book, price-to-sales, Tobin's Q, and market capitalization-to-GDP. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: Nonfarm payrolls fell by 20.5 million in April. The unemployment rate soared to 14.7% from 4.4%. The labor force participation rate declined to 60.2%. However, average hourly earnings increased by 7.9% year-on-year, since most job losses were in lower-income quartiles. Headline inflation fell from 1.5% to 0.3% year-on-year in April. Core inflation declined from 2.1% to 1.4% year-on-year in April. The NFIB business optimism index fell from 96.4 to 90.9 in April. Initial jobless claims kept increasing by 22.9 million last week. The DXY index appreciated by 1.2% this week. On Tuesday, House Democrats unveiled a $3 trillion stimulus package to further aid the economy, including nearly $1 trillion for state and local governments, $200 billion fund for essential worker hazard pay, and an additional $75 billion for COVID-19 testing. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: Industrial production plunged by 13% year-on-year in March. The unemployment rate in France declined from 8.1% to 7.8% in Q1. The euro depreciated by 0.5% against the US dollar this week. The ECB Economic Bulletin released this Thursday highlighted that euro area GDP could fall by between 5% and 12% this year, highlighting uncertainty around the ultimate extent of the economic fallout. More importantly, the ECB Governing Council is fully prepared to increase the size of the PEPP by as much as necessary. 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 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 95.4 to 90.5 in March. The leading economic index fell from 91.9 to 83.8 in March. The trade surplus narrowed from ¥1.4 trillion to ¥1.03 trillion in March. The current account surplus shrank by nearly 40% to ¥1.97 trillion. Bank lending increased by 3% year-on-year in April, up from 2% the previous month. Machine tool orders kept contracting by 48.3% year-on-year in April.  The Japanese yen fell by 0.7% against the US dollar this week. The Economy Watchers’ Survey released this week showed that the current situation index plunged from 14.2 to 7.9 in April. The outlook index also declined from 18.8 to 16.6. It also implied that the situation is likely to deteriorate further, due to the severe challenges posed by COVID-19. 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 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been negative: GDP contracted by 1.6% year-on-year in Q1, compared with a 1.1% increase the previous quarter. Retail sales increased by 5.7% year-on-year in April, up from a 3.5% decline in March. The total trade deficit widened notably from £1.5 billion to £6.7 billion in March. Industrial production fell further by 8.2% year-on-year in March. Manufacturing production fell by 9.7% year-on-year in March. The British pound fell by 1.6% against the US dollar this week, alongside the weak Q1 GDP data. Moreover, the National Institute of Economic and Social Research (NIESR) estimates that GDP will plunge by about 25-to-30%quarterly in Q2. They also pointed out that while some activities will resume with the reopening, there is a significant risk of a second wave which could trigger a further setback in the economy. 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 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed:  The NAB business confidence improved from -65 to -46 in April, while the business conditions index fell from -22 to -34 in April. Westpac consumer confidence ticked up from -17.7 to 16.4 in May. Employment decreased by 594K in April, down from a 5.9K increase the previous month. The unemployment rate increased from 5.2% to 6.2%, however this is well below the expected rise to 8.3%. The wage price index increased by 2.1% year-on-year in Q1. The Australian dollar fell by 1.9% against the US dollar this week. The labour force survey showed that the number of people looking for work declined significantly during the shutdown, which has been one of the main reasons why the unemployment rate did not fall as much as expected. 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 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ business confidence improved from -66.6 to -45.6 in May. Net migration increased by 4,941 in March, compared with a 4,339 increase the previous month. The New Zealand dollar fell by 2% against the US dollar this week. On Tuesday, the RBNZ kept the interest rate unchanged at 0.25%, while increasing its asset purchase programme by up to NZ$60 billion. Moreover, it implied that negative interest rates could be possible as the COVID-19 pandemic continues to disrupt the economy. We recommend holding on to long AUD/NZD positions. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Housing starts declined from 195.4K to 171.3K in April. Building permits plunged by 13.2% month-on-month in March. The unemployment rate soared to 13% from 7.8% in April. The participation rate declined to 59.8% from 63.5%. Employment decreased by 1993.8K in April, better than the expected 4000K drop, while average hourly wages increased by 10.5% year-on-year. The Canadian dollar depreciated by 0.9% against the US dollar this week. The employment loss is led by Quebec, which saw the increase of unemployment to 18.7%. Moreover, while the number of self-employed workers was little changed, there has been a large drop in total hours worked. In addition, the loss of employment was concentrated in accommodation, food services and construction. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices kept declining by 4% year-on-year in April, following a 2.7% decrease in March. Sight deposit increased from CHF 663.8 billion to CHF 669.1 billion for the week ended May 8. The Swiss franc fell by 0.3% against the US dollar this week. Switzerland has entered its second phase of reopening. Schools, businesses, museums and restaurants can reopen as long as they take precautionary measures. However, as a small open economy, Switzerland is heavily dependent on exports and imports, which are curtailed in a global economic recession. 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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Manufacturing output fell by 3% month-on-month in March. PPI plunged by 16.1% year-on-year in April. Headline inflation increased from 0 to 0.4% in April, while core inflation soared from 2.1% to 2.8% year-on-year, led by higher food prices especially imported fruits and vegetables. The Norwegian krone initially rebounded by 2.8% against the US dollar, then gradually fell amid broad dollar strength, returning flat this week. The Norges Bank Executive Board has decided to exclude a list of Canadian oil companies from its government pension fund due to pollution concerns. 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 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Headline consumer prices contracted by 0.4% year-on-year in April. The Swedish krona has been flat against the US dollar this week. The Minutes of the Monetary Policy Meeting released this week showed that the Riksbank is ready to scale up its bond purchases if conditions warrant. Last week, all bank members continued to support asset purchases of up to SEK 300 billion until this September. 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