Developed Countries

Your feedback is important to us. Please take our client survey today. Highlights The dollar remains at risk of a countertrend bounce in the near term. The DXY could rise to 94-96 before working off oversold conditions. Nonetheless, the long-term outlook for the greenback remains bearish. The Scandinavian currencies are best positioned for outperformance over the next 12 months. Stay short USD/JPY as a core holding for now. Remain long silver relative to gold. Sterling volatility will remain elevated in the near term, but short EUR/GBP positions should provide handsome gains over the longer term. Feature The US election is just a week away. The market consensus is that a “blue wave” will usher in significant fiscal stimulus which will boost stock prices, buffet bond yields and drive down the dollar. The rationale behind these anticipated market moves is that the Democrats have been more aggressive in their demand for bigger government. Fiscal spending will widen the US twin deficits as aggregate demand rises. In anticipation of higher inflation, foreign bond investors are likely to continue fleeing the US market, driving down the dollar in the process. Fiscal spending will widen the US twin deficits as aggregate demand rises. We sympathize with this view, but it is unlikely to pan out smoothly. More specifically, a number of indicators suggest that the dollar is at risk of a countertrend bounce. This could lead to an air pocket for dollar-short positions in the near term. Our bet is that the DXY could rise to 94-96 before working off oversold conditions. The Case For A Countertrend Bounce A number of indicators suggest that conditions may be ripe for a countertrend bounce in the dollar. The velocity of money (V) is collapsing around the world (Chart I-1A and Chart I-1B). At a minimum, this suggests that realized inflation is bound to remain tame in the very near term. The dollar is a countercyclical currency, and tends to do well when global inflation is decelerating. In the case of the US, a temporary dip in inflation expectations will boost real rates, and encourage flows back into US fixed-income assets. In a general sense, V can be viewed as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables. Once economic agents start to increase the turnover of money in the system as activity improves, it is an endogenous sign that the economy has escaped a liquidity trap and can handle higher rates. Chart I-1ADownside Risks To US Inflation Chart I-1BDownside Risks To Euro Area Inflation ​​​​The balance sheet impulse of the Federal Reserve could peak soon, relative to a few other countries (Chart I-2). This will especially be the case if other G10 countries step up the pace of their quantitative easing. This is already occurring in Canada and could soon happen in Australia. Remarkably, long-term US interest rates have started rising faster compared to its G10 peers. This was bound to happen as we stepped into a world of competitive devaluations. For most of the post-2008 period, the EUR/USD exchange rate oscillated with the relative balance sheet impulse between the Fed and the European Central Bank. The story in Japan was similar after the Fukushima crisis in 2011 and the subsequent adoption of Abenomics. In short, central bank QE becomes an important driver at the lower bound, since it is the key signaling mechanism on the future path of interest rates. Chart I-2The Dollar And Balance Sheet Impulse Currencies are about relative growth trends. Remarkably, relative growth tends to play a crucial role in currency dynamics even over the short term. For example, the upside growth surprise between the euro area and the US has started to reverse after a sharp V-shaped recovery (Chart I-3). Correspondingly, the euro has been consolidating its gains since August. On a broader scale, the OECD leading economic indicator for the US has picked up relative to its G10 peers (Chart I-4). Chart I-3EUR/USD And Relative Growth Chart I-4The Dollar And Relative Growth The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-5). The AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. This Maginot Line was clearly breached during the March drawdown, but we have since re-entered the safe zone. In recent trading sessions, however, AUD/JPY has been edging lower and could soon punch below the 74 level. Inflows into US equities are rising sharply (Chart I-6). Currencies tend to move in sync with the relative performance of their equity bourses. Correspondingly, non-US equity markets have relapsed relative to the US. Similarly, cyclical stocks have been underperforming defensive ones of late. The dollar tends to weaken when non-US equity markets, with a much higher concentration of cyclical stocks in their bourses, are outperforming. This is usually a clear sign that the marginal dollar is rotating outside of the US. Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). Chart I-5AUD/JPY: Watch The 72-24 Zone Chart I-6Strong Inflows Into US Equities Chart I-7Many Dollar Bears In a nutshell, the market has been ignoring clear bullish signals for the dollar such as the drop in money velocity and the relapse of global interest rates relative to the US. Meanwhile, the consensus is overwhelmingly bearish on the dollar, which could make any bounce or advance go much further than most expect. The catalyst in the near term could be a market reset, given uncertainty around the US presidential elections, the resurgence in COVID-19 cases and Brexit. Meanwhile, unless animal spirits are rekindled by an invisible hand, perhaps in the form of a vaccine, then the outperformance of cyclical stocks, which is needed to boost the aggregate market index higher, is not a sure bet. Similarly, the outperformance of non-US stocks, specifically those in Europe and Japan, is also needed to confirm the dollar bear market remains intact. Positive Catalysts Chart I-8Lumber Versus Copper Despite our concerns of a near-term bounce in the dollar, there are still many signs that it will not be a durable one. Therefore, investors should use any dollar rally to establish fresh short positions. Lumber has started to underperform Dr. Copper. Lumber benefits greatly from a pickup in housing activity in the US and is very closely correlated to US domestic variables, while copper is strongly linked to Chinese and global industrial cycles. The dollar also tends to underperform higher-beta currencies when lumber is underperforming copper, as is the case now (Chart I-8). Similarly, the copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-9). The gold/silver ratio (GSR) has rolled over following the recent bounce (Chart I-10). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR usually peaks as we exit a recession. The bond-to-gold ratio, as measured by the ratio of the US bond ETF (TLT)-to-gold ETF (GLD) remains below the key technical level of 0.90, which is bearish for the dollar (Chart I-11). The ratio measures the shift in confidence between the dollar and alternatives to the fiat reserve currency. The upside for the 10-year Treasury is much more capped than the upside is for gold, suggesting that this confidence measure will remain dollar bearish for the near future. Finally, currency volatility is high, suggesting that currency traders are no longer complacent. Usually, high volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar has benefitted (Chart I-12). Should volatility drop from current levels, especially in early 2021, pro-cyclical currencies will benefit. Chart I-9The Copper/Gold Ratio Leads The Dollar Chart I-10The Gold/Silver Ratio Has Relapsed Chart I-11Watch The Bond-To-Gold Ratio Chart I-12Currency Volatility Is Rolling Over In summary, many cyclical drivers still point to a lower ultimate resting spot for the dollar. Nonetheless, the character of any equity shakeout over the coming weeks will be worth monitoring. If cyclical and value stocks that are already at historically bombed-out levels start to outperform, it will signal an equity market leadership change – something that is required for the dollar bear market to resume. Investment Implications Chart I-13Sell EUR/GBP Chart I-14Place Stops On Short GSR At 80 The investment implications are straightforward. Maintain a basket of the cheapest currencies, together with some safe-havens. Also, focus on trades at the crosses. Specifically: Stay long the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. We also went short CAD/NOK a fortnight ago. EUR/GBP is at risk of a significant selloff if we get a Brexit deal (Chart I-13). We already have limit orders on a few currencies, including a Nordic currency basket, AUD/NZD and EUR/CHF. We are long petrocurrencies versus the euro, and will use any tactical bounce in the dollar to shift to USD shorts. Remain short gold/long silver with a target of 50, but tighten the stop loss to 80 (Chart I-14).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The preliminary Michigan consumer sentiment index climbed up from 80.4 to 81.2 in October. Retail sales increased by 1.9% month-on-month in September. This was a significant beat, relative to expectations of a 0.8% rise. Housing starts increased by 1.9% month-on-month in September. Building permits also increased by 5.2% month-on-month, overtaking pre-pandemic levels. Initial jobless claims increased by 787K for the week ending on October 16th. Claims have consistently come under 1000K since August 28. The DXY index fell by 0.8% this week. It remains evident from incoming data that the US economy is holding up well, relative to its trading partners. Bond yields have also moved in favor of the US dollar. While this could catalyze a countertrend bounce in the DXY, our bias is that it is not likely to be a durable one.   Report Links: Does The US Save Too Much Or Too Little? - October 16, 2020 Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The seasonally adjusted trade surplus increased from €19.3 billion to €21.9 billion in August. This lifted the current account balance from €16.95 billion to €19.94 billion. Both headline and core inflation remained unchanged at -0.3% and 0.2% year-on-year, respectively, in September. Consumer confidence has been rolling over, but much better than you would expect given the resurgence in COVID-19 cases in Europe. The euro increased by 0.7% against the US dollar this week. The critical barometer for the euro outlook is the economic impact from the second wave of the pandemic. During an interview this week, ECB president Christine Lagarde said that the recovery could be “running out of steam.” Economic surprise indices in Europe are also rolling over, relative to the US. This sets the euro up for some indigestion before the bull market resumes. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been mixed: The adjusted trade surplus significantly widened from ¥248 billion to ¥675 billion in September. Exports fell by 4.9% year-on-year in September, up from a 14.8% decrease the previous month. Imports continued to fall by 17.2% year-on-year. The Japanese yen appreciated by 0.7% against the US dollar this week. Sluggish imports reflect weakness in Japanese domestic demand, which is putting upward pressure on real rates. Meanwhile, Suga-san’s push to continue pressuring telecoms to drop prices does not bode well for the BoJ’s inflation target. As such, the yen remains a very attractive currency when real rates are compared across the G10. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been robust: Rightmove house prices surged by 5.5% year-on-year in October. Headline inflation increased from 0.2% to 0.5% year-on-year in September. Core inflation also ticked up from 0.9% to 1.3% year-on-year. CBI trends continue to improve in terms of both orders, selling prices and business optimism. The British pound increased by 0.7% against the US dollar this week. Sterling action will continue to be dictated by the evolution of Brexit. The UK public sector has no choice but to step in as a spender of last resort amid the twin economic and health crises. In fact, net borrowing surged to £35 billion from £29 billion in September, which was more elevated than expected. Rising public debt has pushed Moody’s to downgrade the UK’s sovereign credit rating, warning that Britain “effectively has no fiscal anchor.” That said, positive action on the pound this week reflects the market’s laser focus on the terms of the UK’s withdrawal from the EU, and nothing else. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been soft: The Westpac Leading Index declined from 0.49 to 0.22 in September.  Retail sales declined by 1.5% month-on-month in September. The Australian dollar appreciated by 0.4% against the US dollar this week. The RBA meeting minutes released this week implied further easing from the central bank, which might include further rate cuts and some expansion in its QE program. Interestingly, softness in the AUD, particularly against the NZD is setting the stage for a nice entry point. AUD/NZD slipped by 0.7% on the dovish RBA minutes. Over the longer-term, our fundamentally bullish bias on the AUD is based on strong relative terms of trade, and a currency that remains undervalued. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There has been scant data from New Zealand this week: NZIER business confidence fell by 40% quarter-on-quarter in Q3. Credit card spending fell by 9.9% year-on-year in September, but is a marked improvement from the 48.6% drop earlier this year. The New Zealand dollar surged by 1% against the US dollar this week. Prime minister Jacina Ardern’s election sweep over the weekend has boosted confidence on a more fluid government in New Zealand. That said, our updated PPP models shows that the New Zealand dollar is currently close to its fair value, while other major DM currencies, with the exception of the US dollar, are significantly undervalued. While NZD could rise against the US dollar in the near term, it should underperform at the crosses. We are short on NZD/CAD in our portfolio and it’s 2.5% in the money. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: Headline inflation jumped from 0.1% to 0.5% year-on-year in September. Most measures of core inflation have held steady, but still came in below the midpoint of the BoC’s 1-3% band. The core median CPI came in at 1.9%, similar to last month, in line with expectations. Retail sales continued to increase by 0.4% month-on-month in September, but came in below the expected 1.1% rise. Teranet/National Bank House Prices increased by 6.7% year-on-year in September. The Canadian dollar appreciated by 0.3% against the US dollar this week. The most important release for Canada this week was the Business Outlook Survey, which showed a notable improvement in Quebec, Alberta, and the other Prairies. The pickup in September’s inflation figures also lowered the possibility of further rate cuts when the BoC meets next week. We remain positive on the CAD, expecting it to touch 82 cents versus the dollar over a cyclical horizon. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Exports increased from CHF 16.7 billion to CHF 18.7 billion in September and imports increased from CHF 13 billion to CHF 15.4 billion. As such, the trade surplus slightly narrowed from CHF 3.5 billion to CHF 3.3 billion. The Swiss franc increased by 0.2% against the US dollar this week. Since the March 19 lows, the franc has appreciated by nearly 10% against the US dollar. The unwanted strength in the Swiss franc has been a headache for the SNB. We believe the intervention from the SNB will limit how far the franc can rise, compared to other G10 currencies. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been negative: The unemployment rate rose from 5.2% to 5.3% in August. The participation rate dropped by 0.4% to 70.9% in Q3 compared with the same quarter last year. On a positive note, industrial confidence continues to rebound. The Norwegian krone soared by 1.2% against the US dollar this week. As we frequently highlight in our publications, the Norwegian krone is poised to benefit most from a weaker USD. Moreover, our PPP model shows that at 30% below its fair value, the krone is still the most undervalued DM currency. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There has been no significant data release from Sweden this week. The Swedish krona fell by 0.6% against the US dollar this week. Reuters polls now suggest that the Swedish economy is expected to shrink by only 4% in 2020, rather than by 5% as was previously forecast. The Swedish krona is one of the cheapest currencies in the G10 and will benefit from a post-pandemic recovery. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Your feedback is important to us. Please take our client survey today. Underweight In yesterday’s US Equity Sector Insight we highlighted why investors should stay on the sidelines when it comes to the defensive S&P household products index. But, with regard to the broader S&P consumer staples sector, our view remains that over the next 9-12 months this safe haven sector, which peaked in the depths of the COVID-19 recession, will continue to underperform. As the pandemic-induced recession disappears from the rear-view window, it no longer pays to favor stable cashflow growth staples companies. In fact, our relative macro earnings model paints a dark picture for this GICS1 sector (middle panel). Among other reasons, one of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis staples stocks cannot benefit from positive currency tailwinds to the same extent as the overall market can. Bottom Line: We remain underweight the S&P consumer staples sector.  

Your feedback is important to us. Please take our client survey today. Highlights New position: Go structurally overweight DM equities versus EM equities. This position is equivalent to structurally overweight healthcare versus basic resources. New position: Go cyclically underweight the resource-heavy Finland stock market. Structurally underweight European equities versus DM equities. This position is equivalent to structurally overweight technology and communications. Structurally neutral European equities versus EM equities. This position is equivalent to structurally neutral between healthcare and technology. Cyclically underweight basic resources versus financials. Fractal trade: Fractal analysis confirms that Finland is overbought. Underweight Finland versus Switzerland. Feature Chart of the WeekOverweight DM Vs. EM = Overweight Healthcare Vs. Basic Resources A Major Misunderstanding About Valuation One of the biggest misunderstandings that we come across in investment is in assessing an asset’s valuation versus its own history. It is common to read claims such as ‘asset X is undervalued by two standard deviations.’ Yet these claims often betray a major flaw. The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. In mathematical terms, the time-series must be stationary. If the time-series is non-stationary, meaning that it has undergone a phase-shift, then the concepts of the historical average and standard deviation are meaningless.  The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. To draw a simple analogy, we cannot compare our adult bodyweight with our lifetime average bodyweight. This is because our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our adult bodyweight with the lifetime average it would give the false signal that we were permanently overweight! Clearly, we should compare our adult bodyweight only with its history in the adult phase. Likewise, as the structural prospects for financials and resources phase-shifted at the start of the 2000s, their average valuations also phase-shifted. The average forward price-to-earnings multiple dropped from 13 to 10 for financials and from 18 to 11 for resources. In contrast, the average multiple of healthcare did not phase-shift, remaining at around 17 (Chart I-2-Chart I-4). Chart I-2The Valuation Of Financials Experienced A Phase-Shift Down Chart I-3The Valuation Of Basic Resources Experienced A Phase-Shift Down Chart I-4The Valuation Of Healthcare Did Not Experience A Phase-Shift It follows that we should compare the valuations of all sectors only with their history in their current phase. Unsurprisingly, this shows that healthcare is now modestly expensive versus its history. But surprisingly, and against the popular perception, financials and resources are not cheap. They are expensive versus their current phase history. In fact, the valuation of a long-duration sector such as healthcare should also take account of the bond yield. On this basis, healthcare’s forward earnings yield at 5 percent might look slightly expensive versus its history. But it looks extremely attractive versus the 0.8 percent yield on the 10-year T-bond (Chart I-5 and Chart I-6). Chart I-5Healthcare's Forward Earnings Yield At 5 Percent... Chart I-6...Looks Very Attractive Versus The 10-Year T-Bond Yield At 0.8 Percent This valuation analysis carries repercussions for regional and country allocation, which we will now discuss. What Drives European Equity Performance Versus Developed Markets? Europe recently overtook the US to become the region with the largest stock market weighting in healthcare. The lead is slim. Europe’s stock market exposure to healthcare now stands at 16 percent versus the US at 14 percent, and the lead is mostly the result of Europe’s value sectors withering away. Nevertheless, it does mean that Europe is now the leader in a growth sector, at least in terms of its stock market exposure. That’s the good news.1 The bad news is that European stock market exposure to the other growth sectors – technology and communications – at 12 percent, remains a very distant laggard behind the US, at 40 percent. This is important, because Europe’s massive underweighting to technology and communications versus the US is by far the biggest determinant of the two stock markets’ relative performance. European stock market exposure to technology and communications, at 12 percent, remains a very distant laggard behind the US, at 40 percent. To be clear, currency moves matter too. Stock prices are denominated in the currency of their home stock market, yet the companies that dominate the major stock markets are international companies with multi-currency earnings. If the international currencies appreciate versus the home currency – meaning, the home currency weakens – the stock market gets an uplift from the so-called ‘positive currency translation effect’. Hence, our expectation of a gradually weakening dollar versus European currencies should give the US stock market a mild relative tailwind versus Europe from such a currency translation effect. That said, sector relative moves tend to dominate currency moves. This makes the sector outlook combined with the regional and country sector ‘fingerprints’ the key driver of regional equity relative performance (Tables 1-3). Table I-1The Sector Fingerprints Of Major Regional Stock Markets Table I-2The Sector Fingerprints Of Euro Area Stock Markets Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets Our expectation of long-term outperformance from technology and communications is the main reason to structurally favour the US over Europe (Chart I-7). Chart I-7Overweight Europe Vs. US = Underweight Technology What Drives European Equity Performance Versus Emerging Markets? The European equity market’s combined exposure to the growth sectors – healthcare, technology, and communications – is massively underweight versus the US, and therefore also versus the developed markets (DM) equity index. Interestingly though, Europe’s growth sector exposure is not significantly different to that in the emerging markets (EM) equity index. Europe’s key difference with EM is the distribution of growth sector exposure. Europe has a high exposure to healthcare but a massive underexposure to technology and communications. The emerging markets (EM) equity market is the precise opposite – EM is overweight in technology and communications but massively underweight in healthcare.  Europe versus EM relative performance boils down to healthcare versus technology. The upshot is that Europe versus EM relative performance boils down to healthcare versus technology. Chart I-8 should leave you in no doubt that everything else is largely irrelevant! It follows that investors that favour healthcare versus technology should overweight Europe versus EM. Albeit, right now, we do not have a high conviction on this view. Chart I-8Overweight Europe Vs. EM = Overweight Healthcare Vs. Technology The Case For Overweight Healthcare Versus Resources, And Overweight DM Versus EM Our high conviction view is to overweight DM versus EM. This view boils down to DM’s overexposure to healthcare versus EM’s overexposure to the classic cyclicals, epitomised by basic resources. Again, the Chart of the Week should leave you in no doubt that everything else is largely irrelevant. The long-term case for healthcare versus resources hinges on the outlook for their profits. Healthcare profits can grow, because as economies (and people) mature, they spend a greater proportion of their income on healthcare to improve the quality and quantity of life. In contrast, resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. And even the physical stuff that we do rely on contains less mass. Think about how light your phones, TV screens, and cars are compared to a couple of decades ago. What about the expected surge in resource-heavy infrastructure investment as governments open the fiscal taps? The problem is that as the world changes to a post-pandemic way of living, working, and interacting, it will take a long time to establish which, if any, infrastructure investments make sense. For example, previously sensible high-speed rail links between city centres and extra runways at airports could turn out to be white elephants. Hence, we think that major infrastructure projects may not arrive in the way that the market is anticipating. The short-term case for healthcare versus resources hinges on monetary developments in China. When looking at money supply and bank credit growth and impulses, conventional analysis focusses on 1-year rates of change. We have no objections with that. However, we prefer to focus on the shorter-term 6-month rates of change, because we find that they have a greater predictive power for the financial markets. China’s bank credit 6-month impulse has fallen off a cliff. Right now, China’s bank credit 6-month impulse has fallen off a cliff. When this happened in late 2016, early 2018, and early 2019 it presaged an underperformance of the resources sector. We anticipate the same to happen again, especially given the scale of the drop in the bank credit impulse and the scale of the recent outperformance of the resources sector (Chart I-9). Chart I-9When China's Bank Credit 6-Month Impulse Falls, Basic Resources Underperform Hence, we expect resources to underperform in the short term too, and our preferred near-term expression is to underweight resources versus financials. Looking at sector fingerprints of equity markets, one consequence is that Finland’s resource-heavy stock market is also likely to underperform. Accordingly, go underweight Finland. Fractal Trading System* Supporting the fundamental arguments to underweight Finland, its 130-day fractal structure also appears to be near a tipping-point of fragility. The recommended trade is to short Finland versus Switzerland, setting the profit target and symmetrical stop-loss at 7 percent. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Finland Vs. Switzerland When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Sector weightings based on MSCI indexes. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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Your feedback is important to us. Please take our client survey today. Highlights The signaling of QE programs by central banks has the greatest short-term impact on financial markets. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created excess reserves and deposits, respectively. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Therefore, going forward QE programs will have a greater impact on financial markets than they did in the past ten years. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation in the coming years. Rising velocity of money will be the key to inducing and sustaining higher inflation. Feature There are varying explanations in the investment community over how quantitative easing (QE) programs affect asset prices and consumer price inflation. For example, investors often struggle to dissect the impact of QE on equity prices and exchange rates: (1) Is it the level of central bank assets or their rate of change that affects financial markets? or (2) Is it the signaling mechanism of QE that moves asset prices and currencies? (3) Why did QE programs in the last decade not lead to higher consumer price inflation? We use a question-answer format to elaborate on these and other questions related to QE programs.  QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. Question: Do QE programs amount to money printing? Answer: Not always. QE operations by central banks might or might not create new money supply. First, we have to define money. In all countries, broad money supply is commonly defined and calculated as the sum of cash in circulation and all types of deposits in the commercial banking system. Cash in circulation makes only 11% of broad money supply in the US, 9% in the euro area, 3.8% in China and 7.3% in Japan. Hence, various types of deposits in commercial banks constitute the overwhelming portion of broad money supply. Deposits in commercial banks are not a part of a central bank’s balance sheet. Therefore, neither central bank assets nor liabilities are valid measures or proxies of money supply. Chart I-1A and I-1B illustrates that changes in central bank assets and broad money supply have contrasted greatly.     Chart I-1ACentral Bank Assets ≠ Money Supply Chart I-1BCentral Bank Assets ≠ Money Supply   When central banks expand their balance sheets, they create excess reserves (ERs) “out-of-thin air”. ERs are commercial bank deposits at the central bank. There is a close relationship between ERs and central bank balance sheets as ERs constitute a large part of the latter’s liabilities. As a mirror image of ERs, the asset side of central banks’ balance sheet expands as they acquire securities or originate loans.  However, ERs are not a part of either narrow or broad money supply. In fact, in the last decade QE programs in the US, Japan and the euro area created a lot of ERs but little money supply as can been seen in Chart I-2A and I-2B. Chart I-2ATrends In Excess Reserves And Money Supply Differ Chart I-2BTrends In Excess Reserves And Money Supply Differ   In China, it was the opposite: commercial banks have created a lot of money and expanded their assets even as the central bank has provided little ERs (Chart I-2B, bottom panel).  ERs are liquidity for the banking system; commercial banks use ERs to settle payments among themselves and with the central bank. ERs do not spill over into the real economy as commercial banks do not lend out ERs to companies and households. When a central bank buys securities or lends money, it always creates ERs but it does not always create money supply. Households, companies, non-bank financial institutions, organizations and governments (hereafter, economic agents) use money supply – deposits in the banking system and cash in circulation – to buy goods, services and assets. They do not have access to or do not use ERs. Given that central bank QE operations create ERs but not always money supply (deposits), they have a much more nuanced impact on the money supply. Question: In which cases do QE operations create money supply (or not)?  Answer: Whether a QE operation will lead to money creation depends on the counterparty of the central bank transaction: 1. When the central bank lends to or buys securities from commercial banks, it creates ERs but not money supply (deposits). In this case, the central bank’s balance sheet expands but the amount of deposits/money supply in the banking system does not change (Figure I-1). Figure I-1 This operation creates ERs (liquidity for the banking system) but not money supply/deposits at banks that economic agents can use to purchase goods, services, and assets. That said, commercial banks with a large quantity of ERs might decide to originate more loans/lend more to economic agents so that money supply (purchasing power) can expand. In this scenario, QE operations do not affect money supply directly, but they may do so indirectly. 2. When the central bank lends to or purchases securities from economic agents, both ERs and new money supply/deposits are created “out of thin air” (Figure I-2). In this case, not only do commercial banks get ERs but economic agents also get deposits that did not exist before. These newly created deposits constitute an increase in money supply and boost the purchasing power of these economic agents. Figure I-2 3. Absent QE operations, central banks do not typically directly alter money supply; money is almost entirely created by commercial banks. When a commercial bank buys securities from or lends to economic agents, ERs do not change but a new deposit is created “out of thin air”, therefore the money supply expands. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e., the amount of deposits in the banking system) shrinks. To sum up, QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. When central banks purchase assets from commercial banks, no new money is created. Importantly, the main source of money creation outside QE programs is commercial bank purchases of securities from or loans to economic agents. Changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies. Question: How can we forecast if any particular QE program is going to create more or less money? Answer: There is no way to predict it. All depends on the counterparties involved in central bank transactions. One can only observe the evolution of money supply to gauge the direct impact of a QE program on money supply. Further, commercial bank actions have a great deal of impact on money supply. When the commercial banking system as a whole shrinks its assets (loan book, holdings of securities and other claims or assets), money supply contracts, ceteris paribus. In short, to forecast changes in money supply one need to not only forecast central bank transactions with economic agents (non-banks) but also commercial banks loans to, and purchases of securities from, economic agents. Chart I-3Broad Money Growth: Now Versus Last Decade Question: In regard to their impact on money supply, how do QE programs presently differ from those of the last decade? Answer: The key difference between the outcomes of QE programs this year and the ones undertaken in the last decade is that broad money growth in advanced economies is skyrocketing now but it was tame during the QE programs of the last decade (Chart I-3). To recap, QE programs in the US, Japan and the euro area, over the past 10 or so years have created a lot of ERs but little money supply. The reasons for this are as follows: deleveraging by banking systems in the last decade – commercial banks assets shrank or grew modestly – partially offset QE operations’ boost to money supply. Chart I-4 illustrates commercial banks’ assets contracted in 2009-10 in the US, in 2012-17 in the euro area and in the 1990s in Japan. Shrinking commercial bank assets reduces money supply, ceteris paribus. That is why QE programs of the last decade had a muted impact on broad money supply. Presently, commercial banks assets are rising rapidly in the US, the euro area and Japan. Hence, the simultaneous expansion of both central bank and commercial banks assets ensures much more robust money growth now than during the past two decades. Further, advanced economies are moving from monetary to fiscal dominance as their fiscal policies become much more proactive in stimulating growth. This entails running larger fiscal deficits. Mushrooming government bond supply will have to be absorbed by central banks to preclude a substantial rise in bond yields that can threaten economic expansions. Consequently, central banks will purchase a lot of government bonds not from commercial banks but from governments or other investors. This will directly boost money supply. Finally, commercial banks in DM have plenty of ERs and they do not need to sell their bonds in exchange for ERs like they did when they deleveraged last decade. Hence, DM central banks will primarily be purchasing bonds from non-banks resulting in new money creation. All in all, money supply in advanced economies will grow much faster this decade than it did in the past ten years.       Question: Does the current booming money supply in the US not reflect an overflow of excess savings? Answer: As we discussed in our previous reports on money, credit and savings, changes in money supply are not at all contingent on national or household savings. As was discussed above, outside of QE operations, money is primarily created by commercial banks “out-of-thin air” when they lend to or purchase assets from non-banks. Chart I-5 illustrates that there has been no positive correlation between the savings rate and money supply in China, Korea, Japan and the US. The same holds true for any other economy. Chart I-4Commercial Bank Assets Have Great Impact On Money Supply Chart I-5National Or Household Savings Do Not Drive Changes In Money Supply Chart I-6The US: Household Savings Rate And Money Supply The reason why the surge in US money supply this year has coincided with the rise in the US savings rate is as follows (Chart I-6): the Federal Reserve bought an enormous amount of US Treasury securities creating new money “out of thin air”; households received these fiscal transfers from the government in their bank accounts in the form of deposits. Hence, new money was created as a result of public debt monetization and this occurred before consumers made their choice between spending and saving. Critically, changes in economic agents’ propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. In brief, changes in the propensity to save alter the velocity of money, but not the amount of money supply. Chart I-7Velocity Of Money Explains Changes In Core Inflation Question: What is more important to inflation in goods and services: money supply or the velocity of money? Answer: Empirical evidence shows that the changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies (Chart I-7). Overall, there is no direct link between interest rates and money supply on the one hand and goods and service inflation on the other hand. That said, low interest rates or rapid money growth might encourage economic agents to save less, i.e., spend a larger share of their income. Stronger spending – which leads to an acceleration in the velocity of money – will raise inflationary pressures in the real economy. Even if QE programs succeed in generating rapid money growth, the latter does not automatically bring about higher inflation in goods and services. The willingness of consumers and businesses to consume more is critical to generating consumer and producer price inflation. Question: How does money supply differ from liquidity that flows into financial markets? Answer: Investors and market commentators often refer to “liquidity” as a driving force for financial markets. Yet definitions and calculations of liquidity vary tremendously. What investors refer to as “liquidity” can by and large be classified into three groupings: (1) banking system liquidity (excess reserves); (2) broad money supply (all deposits and cash in circulation) available to purchase goods, services and assets, including securities; and (3) liquidity in asset markets – the portion of broad money supply that is channeled to purchase financial assets. Figure I-3 provides a visual representation of money supply and liquidity groupings. All other measures of “liquidity” generally fall into one of these three groupings. Figure I-3Liquidity Groupings And Linkages Deposits/money supply can be used to acquire both financial and real assets as well as to purchase goods and services. They could also be kept idle. In a given period of time, it is impossible to envisage what portion of deposits in the banking system will be allocated to securities investments. Ultimately, this decision rests with each individual and institutional investor. Therefore, it is impossible to forecast the true size of liquidity flow into and out of asset markets. Chart I-8Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Overall, gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve. In contrast, deteriorating investor confidence can lead to a dearth of liquidity in asset markets, despite abundant broad money supply. This topic of liquidity flows into and out of financial markets was extensively discussed in our report titled A Primer On Liquidity. Question: Is there a shortage of financial assets relative to available liquidity? Answer: Probably yes. QE programs in advanced economies have removed high-quality financial assets – valued at about $22 trillion – from global markets. Yet, money supply has expanded tremendously. This has left more money chasing few assets. The top panel of Chart I-8 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines – presently stand at $4 trillion. Notably, the Fed and US commercial banks have increased their debt securities holdings by $3.2 trillion since February and are currently holding $10.9 trillion of debt securities (Chart I-8, middle and bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. We reckon that cash on the sidelines is equal to 8% of the combined value of US equities and US-dollar debt securities available to non-bank investors, i.e. excluding debt securities owned by the Fed and commercial banks (Chart I-9). There is room for this ratio to drop further to its January 2020 level. Chart I-9Investors' Cash Holdings Ratio Has Room To Drop Further To recap, the amount of liquidity flowing into and out of financial assets is ultimately contingent on investor behavior. When investors are willing to invest, liquidity flows into asset markets. On the contrary, when investors turn cautious, they withhold liquidity and asset prices drop.   Overall, barring negative shocks and relapses in growth, risk assets will be supported by tailwinds of expanding money supply. Conclusions And Investment Strategy The signaling of QE programs by central banks has the greatest short-term impact on financial markets – positive on risk assets and negative on the exchange rate. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created ERs and deposits, respectively. Besides, the amount of securities withdrawn from circulation by central banks relative to assets under management also determines the impact of QE operations on asset prices. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Going forward, QE programs will have a greater impact on financial markets than they did in the last decade because they will create more money supply (Chart I-10). Besides, as central banks absorb more securities, the availability of securities to private investors will decline. This will be especially pertinent if the pool of assets under management expands faster along with rapidly growing money supply. This ceteris paribus warrants high asset prices. Interestingly, Chart I-11 demonstrates that during the last decade there was no positive correlation between G4 QE programs - central banks’ balance sheets - and EM risk assets and currencies. Based on this Chart I-11, during the last decade we often downplayed the importance of QE programs for EM financial markets. Chart I-10Global Money Does Not Always Drive Share Prices Chart I-11DM Central Banks' Assets And EM: No Correlation In The Last Decade   However, we have changed our view on the impact of the current round of QE programs on financial markets since May when we published a report titled Understanding QE Programs In EM And DM.  3. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation. A rising velocity of money will be the key to inducing and sustaining higher inflation. De-globalization, policies targeting income redistribution from high- to low-income households, and the oligopolistic structure of a growing number of industries all argue for higher price inflation in the real economy this decade. Only technological advances and automation will be working the opposite way and thus keeping a lid on consumer price inflation. In short, odds favor higher inflation this decade.  4. Concerning EM financial markets, QE programs in EM and DM are especially positive for EM local currency bonds and sovereign and corporate credit markets. We remain long duration in EM domestic bonds but neutral on their currencies versus the US dollar. We expect a rebound in the US dollar before the end of this year. We will use this rebound in the greenback to recommend investors to be long local bonds without hedging currency risk. As for EM credit markets, we are neutral and expect to buy on a dip. The ability of governments to finance themselves locally will limit the supply of US dollar bonds and support this asset class. The latter will also benefit from DM QE programs. While EM and DM QE programs can meaningfully affect the trend in share prices and currencies, the primary long-term trend in EM equities and exchange rates will depend on the return on capital in their respective economies. A high or rising return on capital will supercharge share prices and lead to substantial currency appreciation. A low or plunging return on capital will weigh on both stock prices and currencies, regardless of QE programs. Equity investors should remain neutral on EM equities versus DM. We are presently short a basket of EM currencies versus the euro, CHF and JPY. For country allocation with equities, local bonds, credit markets and currencies, please refer to tables at the end of each report (pages 17-18). The signaling of QE programs by central banks has the greatest short-term impact on financial markets. 5. Finally, Chart I-12 presents a graph that combines two variables: the increase in broad money supply since February as a share of GDP (X-axis) and each country’s central bank purchases of government bonds as a share of net government bond issuance since February (Y-axis).  Chart I-12Monetization Of Fiscal Deficit And Rapid Money Growth This chart gauges the degree of public debt/fiscal deficit monetization by central bank QE operations and aggregate money creation by the central bank and commercial banks. It reveals that the US, the euro area, the Philippines and Poland since February have experienced a money boom stemming from their central banks buying government bonds. India and Turkey are a notch below them. In the majority of EM countries, central bank QE programs and money creation by banks have been timid. This confirms our theme that the majority of EM except China, Korea, and Taiwan are facing tight budget constraints. This will slow down a recovery in these economies. However, it will also force companies and commercial banks to restructure and boost efficiency. The ones that undertake such restructuring will enjoy a bull market in share prices and their currencies will appreciate in the long run.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Neutral We remain neutral the S&P household products index. A V-shaped economic recovery following a recession has historically been synonymous with this defensive industry underperforming (top panel). However, the uniqueness of the current recession must be taken into account. The US consumer continues to binge on household products, which are currently outpacing overall retail sales growth by 13% year-over-year (middle panel, relative consumer spending shown truncated). This trend is slated to continue until a vaccine arrives as the second wave of infections emerges. The same story holds for foreign consumers who also have an incentive to keep up their spending on US household products: a softer US dollar. A weaker US dollar will boost competitiveness of US exporters, which will translate into robust top line growth (bottom panel). Bottom Line: Given the strangeness of the current recession, we remain neutral the S&P household products index. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX, CHD.