Economy

Highlights President Trump is waffling on fiscal relief. Our constraints-based framework still points to a deal, but the odds have clearly fallen. US and global stocks have rallied despite the fiscal failure. Markets evidently believe stimulus is coming regardless, particularly if Democrats win a blue sweep – our base case election scenario. However, our quantitative election model has boosted Republican odds, flagging a major risk to the blue sweep scenario. Moreover a blue sweep will remove checks and balances on the new administration and thus bring negative surprises that the market is underrating. We maintain our tactical risk-off positioning on the expectation of another leg of election-related volatility. Over a 12-month time horizon we remain invested in reflation plays. Feature Financial markets came around to our “blue sweep” base case for the US election this week. Betting markets shifted sharply after the first presidential debate (Chart 1). Support for Biden surged in national opinion polls while Trump dropped off, albeit to a lesser extent in swing states. Worryingly for the White House, the few polls taken since Trump took ill with COVID-19 on October 2 do not show a sympathy bounce for the president (Chart 2). Chart 1Consensus Forms Around ‘Blue Sweep’ Base Case Chart 2Trump Takes A Dive With Little Time On Clock In a very dangerous turn for the president’s re-election chances, Trump discontinued negotiations with House Democrats over a fiscal relief bill, promising to pass a large new stimulus after the election. Partially walking back those comments, he said he would sign any targeted stimulus bills that Congress sends him in the meantime (such as a new round of $1,200 rebates for households). House Speaker Nancy Pelosi shot down the option of a skinny bill, as we have argued she would. Now they are going back and forth. While the S&P 500 rallied on the news, other reflation trades like US cyclicals, oil, and silver show the risk of premature fiscal tightening (Chart 3). Investors may have to wait until late January until getting a new infusion of government support. Chart 3Lack Of Stimulus Still A Risk To Reflation Trades Chart 4Market Rally Not Based On Blue Sweep Odds True, a fiscal deal could be passed in the lame duck session in November or December, but Republican Senators unwilling to pony up around $500 billion to bail out blue states – when they face a possible wipeout in a historic election – will be even less willing if they lose the election. They will be more hawkish since they will want to pin deficits on the Democrats in future. If Republicans retain control of the Senate despite the latest news – which is possible, especially given the Democratic candidate’s new vulnerability in the North Carolina race due to a sex scandal – then investors have two years of fiscal hawkishness to contend with. Diagram 1 highlights the market implications of this Senate risk. Diagram 1Scenarios For US Election Outcomes And Market Impacts So we need to look elsewhere to explain why the market rallied when odds of a fiscal deal fell. The above reasoning leaves us with the following options: The economy is recovering so robustly that new fiscal stimulus is unnecessary. This is not the view of Federal Reserve Chairman Jay Powell, who all but pleaded for Congress to conclude a deal to secure the recovery, or of other mainstream economists. Stimulus is coming regardless of election outcome. Congress will be forced to support the country during a slump. Debt monetization is the relevant point, even if there is a month-or-two delay in stimulus. Financial markets are cheering the higher odds of a Democratic clean sweep of Congress and the White House since it implies fiscal largesse. The market may already have discounted some of the impending tax hikes over the past month. The second explanation is the best but the third is rapidly becoming the new consensus on Wall Street. Chart 4 suggests there is no connection between the S&P rally and the odds of a blue sweep. With the Fed pursuing “maximum employment” and average inflation targeting, it makes sense that the real mover in the macro landscape has become fiscal policy. Hence the outcome that produces the most proactive fiscal policy is positive for financial markets. A blue sweep is verification of the shift toward debt monetization, which is missing from option two above. The problem is that a blue sweep also brings downside risks. Domestic policy uncertainty will only fall temporarily after the election if there is a blue sweep. Checks and balances will vanish. Eventually Democrats will become overweening in their policy agenda, delivering negative surprises to financial markets. A “New Deal”-style policy agenda would weigh on the corporate earnings outlook. For example, Democrats have refused to forswear removing the filibuster or stacking the Supreme Court, both of which would lie in their power and either of which would enable them to pass an ambitious “New Deal”-style policy agenda that would bring unforeseen consequences – largely in the direction of wealth redistribution away from corporations. Table 1What EPS Hit To Expect? Redistribution would start to correct US social and economic imbalances, improve middle class spending power, and boost consumption – but it would first weigh on the corporate earnings outlook. Net profit growth, which grew by 16% above what was otherwise expected due to the Trump tax cuts (Chart 5), could suffer more than the expected 11% one-off contraction (Table 1), as our US equity strategist Anastasios Avgeriou has shown. Chart 5Partial Repeal Of Trump Tax Cut Bad For Earnings New proposals will also emerge that the market is not taking account of. To take just the latest example, former Fed Chair Janet Yellen recently stated that the US could adopt a $40 per ton tax on carbon emissions under a Biden administration.1This proposal is not part of Biden’s official plan, hence not priced by markets along with Biden’s expected tax hikes (Table 2). But control of the Senate would make it a real option given Biden’s ambitious climate goals. Table 2Biden Needs Senate To Raise Taxes Consumer confidence in the US will suffer from political polarization. Recall that in 2016, the economy was in fine shape but Republicans did not believe it, weighing down the average until President Trump won the election. Today the economy is in a slump but Republicans may not recognize the bad news until President Trump loses. Democrats, for their part, will suddenly abandon their doom and gloom if Biden wins the election. Applying a comparable partisan shock to consumer confidence for 2021 would suggest that overall confidence will be lackluster (Chart 6). At least this is true until the passage of new stimulus and an advancing recovery outweigh the partisan effect. Chart 6Biden Will Not Recreate Trump Confidence Boost A similar case can be made that small business sentiment will worsen in a blue sweep scenario. Fear of higher regulation and taxes will spike and weigh on animal spirits (Chart 7). Historically the first year after an election sees smaller equity upside and larger downside with unified government as opposed to divided government (Chart 8). If this time is different it is because of the sea change in the US to embrace debt monetization. But that sea change occurred under a Republican administration and is likely to persist due to the output gap. Chart 7SMEs Will Fear Blue Wave Chart 8Stock Market Profile Fits Divided Government, Which Has More Upside A Republican Senate under a Biden presidency would bring higher fiscal risk, but the truth is that neither trade war risks nor corporate taxes would go up, yet Republicans would eventually have to concede to spending bills (just as Democrats did under Trump). Hence divided government is not as negative as it is made out to be as it contains mostly known quantities, whereas a blue sweep would lead the US in a redistributionist direction that is initially disruptive. Relative to divided government, it would be positive for aggregate demand but negative for corporate earnings. Bottom Line: US and global equities will rise over the coming 12 months on the back of eventual US stimulus and ongoing global stimulus. A blue sweep is our base case election outcome but it brings mixed results. Global equities would benefit more than US equities which will face a spike in taxes and regulation. US equities will still rise but they face more upside under a divided government in which Republicans halt tax hikes. Supreme Court Confirmation Looms Of course, a blue sweep outcome is not guaranteed. Indeed the fact that it is now consensus makes us nervous, as there are still 26 days until the election. Our quantitative election model gives the Republicans a 49% chance of winning the White House on the back of the V-shaped recovery in the states, which delivers Florida to the Republican camp, leaving Trump with 259 Electoral College votes (Chart 9). This probability is well above our subjective 35% judgment and the new market consensus on Trump’s odds. Chart 9Quant Election Model Gives Trump 259 Electoral College Votes And 49% Odds Of Victory Trump’s decision to break off the fiscal talks probably sealed his doom, but we would still maintain that a correct reading of the various political and economic constraints point toward a fiscal deal. Hence there is still some chance that a deal will be snatched from the jaws of defeat. At that point we would upgrade Trump’s chances to something closer to our election model. But it would not be bullish, as the market would need to price a higher risk of trade war. Subjectively Trump has a 35% chance of re-election, but our quant model flags a risk to this view. The market also must contend with COVID-19 risks (Charts 10A and 10B). Stimulus is necessary to prevent COVID-19 risks from hitting the market, as more distancing will be necessary in states where cases are rising. Chart 10ACOVID-19 Cases Rising Chart 10BCOVID-19 Hits Swing States The reason President Trump cut short the fiscal talks was to ensure that they would not interfere with the Senate’s ability to confirm his Supreme Court nominee Amy Coney Barrett. The confirmation hearings will go up for a floor vote in the Senate sometime around October 23, ensuring a massive constitutional brawl just ahead of the election. The dollar has more upside if Trump wins. Chart 11Risk: Trump Comeback Boosts The Greenback We do not expect this showdown to change the game, since boosting turnout among Trump’s conservative base will be insufficient in an election fought in the face of major national shocks that affect the median voter (pandemic, recession, social unrest). This election is already going to be a high turnout election – preliminary information suggests it could be the highest since 1908 at 65% of eligible voters2 — which means that Republicans will suffer from the leftward tilt of the median voter. However, if Trump’s polling improves between now and then – and if mFarkets inexplicably rally all month despite the withdrawal of fiscal support – then we could be surprised. Our quantitative model provides a basis for believing that Republicans are now underrated. This implies that the dollar has more upside in the near term as the risk of a contested election and/or a Trump second term, and hence another shock to the US political system and global trading system, must still be guarded against (Chart 11). Investment Takeaways The market faces near-term downside risk and volatility until the US fiscal support is restored. This is particularly the case as long as COVID-19 cases are not subdued. The rising odds of a blue sweep, our base case, is not sufficient to dampen volatility over the coming month. Depending on the election results, volatility will subside in November or January at the latest. Not only is a contested election a non-negligible risk – based on our quant model’s reading – but also President Trump will remain in office till January 20 and could easily dish out some negative surprises, particularly on China relations. Hence we are maintaining our tactical risk-off and safe-haven trades: long US treasuries, Japanese yen, US health care equipment stocks (which will outperform the overall sector amid the Democratic regulatory threat), and EUR-GBP volatility. Over the 12-month time frame, we have little doubt that the US adoption of debt monetization, in keeping with Chinese and global stimulus, will push equities and risky assets higher. The reflation trade remains the core of our strategic portfolio. Global stocks should outperform under a Biden presidency. Biden will be positive for global trade ex-China, as both US electoral politics and grand strategy will drive any administration to take a hard line on China, though Biden will not wield tariffs like Trump.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Matthew Green, "U.S. could adopt carbon tax under a Biden presidency, ex-Fed Chair Yellen says," Reuters, October 8, 2020, reuters.com; see also Group of Thirty, "Mainstreaming The Transition To A Net-Zero Economy," October 2020, group30.org. 2 See John Whitesides, "More than 4 million Americans have already voted, suggesting record turnout," Reuters, October 6, 2020, reuters.com.

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Chart I-13Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Long-term investors who can tolerate volatility should buy SEK/USD for a potential 20 percent upside. Short-term investors who cannot tolerate volatility should buy CHF/USD. The dollar’s short-term moves are a perfect mirror-image of the global stock market. US and euro area long-duration bond yields will ultimately converge… …and the euro area’s huge trade surplus with the US will vanish. Fractal trade: Underweight European retailers versus market. Feature Chart of the WeekSEK/USD Is 20 Percent Undervalued Relative To The Sweden/US Bond Yield Differential The demand for a foreign currency serves one of four purposes: To buy goods and services denominated in the foreign currency. To buy long-term investments denominated in the foreign currency, also known as foreign direct investment (FDI). To buy shorter-term financial investments like bonds and equities denominated in the foreign currency, also known as portfolio flows.1 To buy currency reserves denominated in the foreign currency. What Sets The Broad Level Of EUR/USD? Looking at the euro, three of the four components of demand tend to change relatively slowly. The net foreign demand for euro area goods and services is not particularly volatile. Neither is FDI. Demand for euro reserves also tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.  All of which means that the usual driver of demand for euros are portfolio flows (Chart I-2). Chart I-2Euro Area Portfolio Flows Have A High Amplitude Portfolio flows are of two main types: fixed income and equity. However, in the euro area, fixed income portfolio flows usually have the much higher amplitude (Chart I-3). The reason is that most savings are invested in fixed income assets. For example, German households hold 80 percent of their assets in fixed income, cash, or close proxies. This explains why the stock of government fixed income securities in the euro area is almost twice as large as the market capitalisation of all the euro area’s stock markets (Chart I-4). Chart I-3Euro Area Fixed Income Portfolio Flows Have A Higher Amplitude Than Equity Flows... Chart I-4...Because Euro Area Fixed Income Is The Dominant Asset-Class What causes fixed income flows to flood out of the euro area one moment and back in the next? The answer is the expected change in interest rates. The main issue is not the exact timing of short-term interest rate changes. Instead, it is the so-called terminal rate: the average interest rate over the very long term, proxied by the long-duration bond yield. Fixed income investors gravitate to the bonds with the highest potential returns adjusted for currency hedging costs or likely currency moves. In the euro area, fixed income portfolio flows have a higher amplitude than equity flows. When the expected interest rate in the euro area declines relative to that in the US, it diminishes any further price upside of euro area bonds compared with that of US T-bonds. Hence, fixed income investors shift out of the less attractive euro area bonds into US T-bonds. The outflow continues until it has depressed EUR/USD to a level where the potential upside to the exchange rate becomes symmetrically more attractive. At this new lower level for EUR/USD, the fixed income portfolio outflow stops because a new equilibrium has been established. International fixed income investors have less upside from the euro area bond price, but they now have symmetrically more upside from the cheaper EUR/USD – and the two factors cancel out. Chart I-5 provides powerful evidence of this dynamic. For the past 15 years, the broad territory in which EUR/USD trades has been a close function of the euro area/US long-duration bond yield spread.3 A zero yield spread equates to EUR/USD in the broad territory of 1.35 with every +/-100 bps equal to +/- 15 cents. Hence, the current yield spread of -100 bps equates to EUR/USD trading in the broad territory of 1.20. Chart I-5The Euro Area/US Bond Yield Differential Sets EUR/USD... Interestingly, the euro area/US trade imbalance is also a close function of the bond yield spread. This confirms that the euro area’s massive trade surplus with the US is the direct result of the massive imbalance in relative monetary policy – which depressed EUR/USD and boosted the euro area’s relative competitiveness. Put simply, at a narrower (and more normal) bond yield spread, the euro area’s trade surplus with the US would largely vanish (Chart I-6). Chart I-6...And Thereby It Sets The Euro Area/US Trade Imbalance The Euro Area/US Yield Spread Is Likely To Narrow Further The long-term evolution of EUR/USD – as well as the associated trade imbalance – hinges on the long-term evolution of the euro area/US long-duration bond yield spread. Will this spread widen or narrow? At a narrower bond yield spread, the euro area’s trade surplus with the US would largely vanish. From the euro area side, the answer is easy. The spread cannot widen, it can only narrow. With the ECB policy interest rate already expected to be stuck at its lower bound indefinitely, down is not an option. From the US side, the spread could go either way, at least mathematically. However, it is our high conviction view that in the long term it will narrow. The Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric. The central bank has told us that it will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. Hence, when the slightest further deflationary shock comes – and sooner or later it will – US long-duration bond yields will converge with those in the UK and Japan in one of two ways. Either the Fed will follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or the Fed will follow the Bank of Japan in formally implementing yield curve control (Chart I-7).   Chart I-7The US Bond Yield Will Converge With The Others Buy SEK/USD For The Long Term, Buy CHF/USD For The Short Term Other European economies also exhibit the same strong link between their exchange rates with the dollar and their bond yield spreads with the US. In the case of Sweden, there is an attractive opportunity. SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread. Hence, the long-term case for owning SEK/USD does not even require the yield spread to narrow from where it stands today. Of course, if the spread did narrow by a further 50 bps, the potential upside would approach 30 percent (Chart of the Week). SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread.  Nevertheless, for short-term investors, there is an important caveat. While fixed income portfolio flows drive the long-term values of European currencies versus the dollar, equity portfolio flows become dominant in periods of market stress. During such dislocations, equity flows tend to flee to perceived haven assets and markets, many of which are denominated in dollars. As a result, the dollar rallies. The compelling proof is that over the past year, the dollar has traded as a perfect mirror-image of the global stock market (Chart I-8). Chart I-8The Dollar In 2020 = A Perfect Mirror-Image Of The Stock Market In Europe, the haven currency is the Swiss franc. Hence, while SEK/USD fell by 10 percent during this year’s market turbulence, CHF/USD remained unperturbed. Furthermore, CHF/USD is also undervalued relative to its relationship with the Switzerland/US bond yield spread.4 Albeit, the undervaluation is more modest, at around 6 percent (Chart I-9). Chart I-9CHF/USD Is Modestly Undervalued Relative To The Switzerland/US Bond Yield Differential The conclusion is that long-term investors who can tolerate volatility should buy SEK/USD for its greater upside. Whereas short-term investors who cannot tolerate volatility should buy CHF/USD for its greater safety. Fractal Trading System* This week we note that the recent strong outperformance of European retailers is vulnerable to a trend reversal, and especially so if the pandemic resurges. Accordingly, the recommended trade is underweight European retailers versus the market (which can be implemented as EXH8 versus Euro Stoxx 600). The profit target and symmetrical stop-loss is set at 4.2 percent. Chart I-10European Retailers Vs. Market The rolling 1-year win ratio now stands at 56 percent. 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. Footnotes 1 In this discussion, portfolio flows include short-term speculative flows. 2 For example, when the Swiss National Bank broke the franc’s peg with the euro in early 2015, it abruptly stopped buying euro reserves. 3 The euro area bond yield is the issue-weighted average of the euro area’s constituent sovereign bond yields. A good approximation of the euro area’s issue-weighted average is the French bond yield.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Dear Client, Next week I will present our outlook on China’s economic recovery, the direction of economic policy and financial markets for the rest of the year and beyond in two live webcasts. The webcasts will take place next Wednesday, October 14 at 10:00AM EDT (English) and Friday, October 16 at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). Best regards, Jing Sima, China Strategist   Feature We have changed the format of our monthly China Macro And Market Review to deliver our messages more concisely and effectively. This week’s report consists of charts that are the most market relevant. Many charts are either self-explanatory or convey a message with brief comments. These charts present macro fundamentals as well as price signals and valuation profiles of China’s financial markets. Our key observations and investment conclusions are as follows: Recent economic data points to a broadening economic recovery in China. The demand side continues to accelerate, and its pace has outstripped production for three consecutive months. Both external and domestic demand measures jumped to above the 50 boom-bust threshold in September’s manufacturing PMI. Service PMI saw the largest monthly uptick since 2013. Credit expansion remained robust through August. Medium- and long-term bank loans to corporates have partially offset the dwindling short-term loans since May, suggesting that near-term liquidity constraints among corporates may be easing. Moreover, an improving bank loan structure will help to boost corporates’ Capex investments. As noted in last month’s China Macro and Market Review,1 the consistent outperformance in production recovery relative to demand in H1 this year has led to an inventory buildup. The ongoing inventory destocking has impeded China’s imports of major commodities and led to a weakening of commodity prices in the past two weeks. The continued destocking of commodities suggests that China’s demand for commodities will remain soft into Q4. Beyond Q4, however, the acceleration in both domestic and external demand should provide solid support to the ongoing economic recovery. Local governments still hold a substantial amount of unspent proceeds from special-purpose bonds issued earlier this year; the funds must be invested in infrastructure projects. We expect China’s imports of industrial raw materials to bounce back in Q1 2021 once the current inventory destocking runs its course. We remain overweight Chinese domestic and investable stocks in a global portfolio in the coming six to nine months. Even though Chinese share prices have run ahead of the country’s business cycle and have priced in an earnings recovery, they are still less overbought than their global peers. China’s economic recovery remains solid compared with other economies, thanks to its successful containment of the domestic COVID-19 outbreak. In absolute terms, we think Chinese stocks still have ample upside potential, as both monetary and fiscal stances remain historically accommodative and the economic recovery is accelerating. Recent setbacks in onshore and offshore stocks were due to the ripple effects from global equity selloffs. Escalating Sino-US frictions have had a very limited effect on China’s overall market because US sanctions are mostly targeted at individual technology companies. There is an elevated risk of a near-term correction in global equity prices, particularly in the next four weeks leading up to November’s US presidential election. In our view, these corrections will provide good buying opportunities. Both Chinese government bonds and onshore corporate bonds remain attractive in a global fixed-income portfolio, based on their higher yields and better risk-reward profile relative to their global peers. Within China’s onshore bond portfolio, returns on corporate bonds have consistently outperformed their duration-matched government bonds. We continue to recommend onshore corporate bond positions in the next 6-12 months.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Chart 1A Widening Economic Recovery Chart 2Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021   Chart 3ALocal Governments Still Have Plenty Of Unspent Fiscal Firepower The divergence between total social financing and M2 growth during the past two months was mainly due to the lack of synchronization between government bond issuances and fiscal spending. Bond issuances are included in social financing and have pushed up fiscal deposits. Fiscal deposits do not derive M2 until they are eventually transferred into fiscal spending. Therefore, we expect that M2 growth will catch up in a few months. Most of the proceeds from government bond issuance have not been dispensed. Local governments have more than enough firepower to continue to support infrastructure spending in the next two quarters. Chart 3BChina's Bank Loan Structure Is Improving Chart 3CLoan Demand And Loan Approvals Have Revitalized Chart 4AChina's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... Chart 4B...And Will Benefit From A World-wide Economic Recovery Chart 5Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Chart 6A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector   Chart 7AMounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Chart 7B...But Near-Term Real Estate Construction Should Still Hold Up As noted in last month’s China Macro And Market Review,2 recently tightened financing regulations on real estate development3 are not game changers. Historically, the government’s financial rules and land sales have not had a strong positive correlation with real estate investment growth. So far, Chinese authorities have kept property policies flexible, allowing most local governments to have their own housing policies. We expect property restrictions will tighten on tier-one and tier-two cities that are facing upward pressure on housing prices. Housing demand in smaller cities, however, remains soft and may see increased policy support next year.  Chinese policymakers will continue to keep an eye on real estate speculation. In the near term, however, real estate developers need to complete their existing projects, which will support construction activities into H1 next year.   Chart 8AHousehold Consumption Continues To Recover Chart 8BRising Employment Should Further Lift Consumption   Chart 9AChina's Offshore And Onshore Forward Earnings Have Ticked Up Chart 9BValuations In A Shares Are Not Too Extreme   Chart 9CChinese Stocks Are Not Expensive Compared With Global Benchmarks Chart 10AChina's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China offshore cyclical stock prices have been driven by hefty valuations since 2016, mostly because investable cyclicals are heavily weighted in high-flying tech stocks. Chinese tech stock prices will likely be extremely volatile in the next one to three months. We expect a tougher stance on China from the US in the next four weeks leading up to the presidential election. Furthermore, even if Trump does not get reelected, the “lame duck” President may still impose sanctions on China before he leaves the White House in January 2021. We are staying the course with our constructive cyclical view on Chinese stocks, even though the market will be more volatile during the next few months. Chinese tech company stocks have been shaken by negative surprises relating to frictions with the US.  However, investors also cheer on even the slightest easing of tensions between the two countries.4 We expect this risk-on and -off sentiment to intensify through Q4. Onshore cyclical stocks have consistently underperformed defensives, driven by a downtrend in relative earnings per share. However, improvements in economic fundamentals of late suggest that the uptick in domestic cyclicals may be strengthening. We remain long on onshore and offshore consumer discretionary and materials relative to their respective broad market indexes. The investment calls are in place until policy dividends on those sectors subside, which we expect in mid-2021. Chart 10BChina's Equity Sectors In Perspective Chart 10CChina's Equity Sectors In Perspective Chart 11AA Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors Chart 11BChinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 3China's widely circulated but unofficial "three red lines" policy sets limits on bank borrowings: a 70% ceiling on a developer’s debt-to-asset ratio after excluding advance receipts; a 100% cap on the net debt-to-equity ratio; and a requirement that short-term borrowing does not exceed cash reserves, according to S&P Global Ratings. 4Please see China Investment Strategy Weekly Report "Sticking With Chinese “Old Economy” Stocks In A Widening Tech War," dated August 12, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations