Equities

Special Report

Highlights Iran is second only to China as a target for President Trump during his “lame duck” two months in office. There is plenty of spare capacity to absorb oil supply disruptions, however. President-Elect Biden will rejoin the 2015 Iranian nuclear deal, but the process will be rocky and we are far from a balance of power in the Middle East. The impact on oil supply is positive but the recovery of global demand will push oil prices up over time regardless. Now is not the right time to go long Middle Eastern equities as a reflation trade. We favor the Trans-Pacific Partnership countries. Israeli stocks can continue outperforming Middle East bourses as a whole, but the rotation from growth to value stocks will benefit other bourses. Prefer the UAE to Turkey, where a large political risk premium will persist. Feature Dear Client, With the US election largely complete, this week marks the return to our regular coverage of global market-relevant political risks. Over the past several months we have focused heavily on every aspect of the US election. The effort was worth it: our final forecast of Democratic White House and a Republican Senate came to pass and our trade recommendations generally performed as expected. Nevertheless it is time to refresh and expand our views on other markets and topics. Geopolitical Strategy has always been – necessarily – a global service offering global coverage. Recent events in China, Europe, Russia, Turkey, and the Middle East demand greater attention – and clients have told us as much. Moreover, with promising vaccine candidates on the horizon, major questions are emerging about what the post-pandemic world will bring. To this end we are returning to our roots with weekly offerings on the full range of global affairs. This week we give you a Special Report on the future of the Middle East by one of BCA’s up-and-coming strategists, Roukaya Ibrahim. We know you will find her post-Trump outlook on the region insightful. As always, we look forward to hearing from you about your research needs and what we can do to answer your geopolitical and investment questions in a timely and actionable manner. Sincerely, Matt Gertken Vice President Geopolitical Strategy The Middle East is about to become a major source of geopolitical risk again. First, President Trump remains in office for two months and is rushing to cement his legacy on the way out. Second, President-Elect Joe Biden will likely face gridlock at home and therefore concentrate the first two years of his presidency on foreign policy. Iran is a priority for both presidents. Biden will rejoin the Joint Comprehensive Plan of Action (JCPA), the 2015 nuclear deal with Iran, which Trump pulled out of in 2018. The purpose of the JCPA was to wind down the US war in Iraq and then “pivot” to Asia, where the US has a much greater interest at stake in managing China’s rise (Chart 1). Chart 1Biden To Restore Obama's 'Pivot To Asia' Chart 2Squint To See Iran ... US Will Focus On China China poses a major challenge to the US while Iran poses a minor challenge (Chart 2). Biden’s aim will be to restore President Obama’s legacy. Given that the US president has unilateral authority on foreign policy, and that the 2015 deal was an executive deal without Senate approval, Biden has a good chance of success. But conditions are much less propitious than in 2015. He will not improve on the terms of the 2015 deal. Any return to a nuclear agreement and deeper understanding with Iran should ultimately reduce tensions in the Middle East. But the pathway to a new regional power equilibrium is rocky. So geopolitical risk is frontloaded and will be a near-term negative factor for Middle Eastern equities, which otherwise stand to benefit from global economic recovery. Restoring Iranian oil exports will increase global oil supply but geopolitical conflict will occasionally reduce supply. As always Iraq, wedged between Iran and US allies, is the central battleground for the power struggle in the Middle East (Map 1). Over a six-to-twelve month time frame, the global economy should recover and oil prices should trend upward. Map 1The Persian Gulf Is Filled With Black Swan Risks Biden Looks To Withdraw Like Obama And Trump Chart 3Biden May Regulate, But US Stays Energy-Independent The US’s ascent toward energy self-sufficiency and its geopolitical decline vis-à-vis China have forced Washington to revise its foreign policy over the past decade, resulting in a strategic divestment from the Middle East (Chart 3). The “Pivot to Asia” is a strategic reality evident in the shift in US military commitments – and Trump has ordered new drawdowns on his way out of office. China’s increasing geopolitical pressure on Australia and rising saber-rattling in the Taiwan Strait highlights the need for the energy-independent US to attend to allies elsewhere. The American public’s view of the Middle East as a strategic quagmire is now producing its third presidency. Obama, Trump, and Biden have all pledged to end the country’s “forever wars” in various ways. The risk to this trend, ironically, was Trump’s aggressive policy on Iran. He revoked Obama’s signature diplomatic achievement and tried to squash Iran’s regional role through “maximum pressure” sanctions and occasional military strikes. He also reinforced US allies Israel and Saudi Arabia, rather than trying to rein them in as Obama had done. Biden’s victory implies that the US will once again favor diplomacy and détente with Iran. Although Iran may make a show of resistance to Biden’s overtures and raise its price so as not to appear to have capitulated to the US, it ultimately has little choice. Its economy is on its last legs, it faces widespread popular unrest, and its sphere of influence is crumbling. Hence constraints on both sides point to a restored nuclear deal. The first obstacle is immediate. President Trump’s “lame duck” period through January 20 is a window of opportunity for Israel or Saudi Arabia to make strategic gains while still enjoying full American support. We highlight the allies because they have much more to fear from Iranian power than the US, and more to lose if the Biden administration appeases Iran. The Trump administration has allegedly reviewed options to launch strikes against Iran since the election, but he has also allegedly ruled against them (as in June 2019). While Trump could still take some kind of action, he would likely face obstruction from the Department of Defense if he tried to do anything that would trigger a full-fledged war in his final two months. It falls to the allies then – or Iran – if conflict is to erupt in the near term. Obama, Trump, and Biden have all pledged to end the country’s "forever wars" in various ways. Cyber-attacks on Iranian nuclear sites this summer are a case in point (Table 1). Suspicious explosions, including at the preeminent Natanz nuclear site, were rumored to be the work of Israel and the United States and raised the specter of a military escalation. However, Iran stuck to its policy of “strategic patience,” hoping for a Biden win. Table 1US And Israel Suspected Of Sabotaging Iran This Year It is possible that elements within the Iranian regime, such as the Iranian Revolutionary Guard Corps (IRGC), could launch attacks to deter further sabotage against their infrastructure and capabilities. The IRGC is focused on rigging the 2021 presidential election and ensuring its ascendancy within the Iranian state ahead of the 82 year-old Supreme Leader Ali Khamenei’s succession, so it cannot be assumed to be quiet. The legacy of the outgoing President Rouhani – a relative moderate in Iran’s political scene – hinges on the success of the 2015 agreement, which he pledged would bring economic prosperity to Iran. The deal’s near-collapse has blighted this legacy and triggered a resurgence of hardliners in Iranian politics. This is clear from the February legislative elections in which hardliners won by a landslide (Chart 4). The hardening of the regime will continue, as Khamenei and the IRGC are increasingly focused on solidifying the regime’s security and authority prior to the succession. The next president will almost certainly be a hardliner reminiscent of Mahmoud Ahmadinejad. Oil price volatility should be expected, but over time the vaccine will secure the global economic recovery and oil prices will rise. Still, we assign low odds to Iran instigating a war or pulling out of the JCPA. The past two years have raised the specter of regime collapse. Khamenei is more likely to keep his eye on the prize: a diplomatic agreement with Biden that eases sanctions and thus enables the regime to live to fight another day. This would be his crowning achievement. The change in US leadership offers Tehran an excuse to renegotiate the 2015 deal and blame Trump as an idiosyncratic deviation from an agreement that lay in Iran’s interest. As long as Khamenei retains control of the IRGC this is our base case. Israel is limited in its ability to wage war against Iran alone, but it is not incapable of surgical strikes to set back the clock on the nuclear program, especially if the Trump administration is there to provide assistance in an exigency. The risk is not negligible. Trump’s former National Security Adviser H. R. McMaster has already warned that Israel could act on the “Begin Doctrine” of preemptive strikes against would-be nuclear powers in its neighborhood. While the near-term risk of conflict would remove oil supply, there is a simultaneous risk that cartel behavior would increase supply. Iran’s regional rivals have an interest in preventing a US-Iran deal, but they could not do so in 2015 and ultimately cannot do so today. Therefore they will seek to shore up their political strength in Iraq while undermining the Iranian economy. Saudi Arabia and other oil-producing GCC states benefit from the maximum pressure sanctions that have wiped out Iranian crude exports. The collapse in oil markets is weighing heavily on these economies. An Iranian deal would bring an additional 1mm b/d – 1.5 mm b/d of crude to global markets in short order. Arab petro-states will not cut back on their own production to make room for Iranian crude. They may try to grab greater oil market share ahead of any surge in Iranian exports. In the current oil market environment, Iran has more to lose from the status quo than do its Arab rivals. While ongoing conflict would add to the multiple crises facing Arab oil producers, the risk to oil production is less relevant today than it was at the top of the business cycle. OPEC 2.0 production is ostensibly capped at 36.42 mm b/d but there is plenty of spare capacity to make up for conflict-induced losses (Chart 5). Chart 4Hardliners Roaring Back To Power In Iran Chart 5Plenty Of Spare Oil Production Capacity Bottom Line: Biden’s election ensures that he will try to revive the Iranian nuclear deal and pivot to Asia. While this is positive for Middle Eastern stability over the medium term, it comes with near-term risks. A “lame duck” President Trump or Israel could strike out against Iran. The Gulf Arabs will do what they can to undermine Iran as well. Oil price volatility should be expected, but over the long run the main tendency will be for the global economy to recover and hence for oil prices to rise. Iraq: A Persistent Source Of Instability Iraq is the fulcrum of the US-Iran conflict, as witnessed in January with the US assassination of Quds Force commander Qassem Suleimani. Torn between Tehran and Riyadh, Baghdad remains in political crisis and is the chief battleground in the regional power struggle. Prime Minister Mustafa al-Kadhimi is still struggling to bring Iraq’s various militias, many backed by Iran, under the control of the state. The US embassy, military bases, and other interests have been under attack throughout the summer, prompting Secretary of State Mike Pompeo to threaten to withdraw the US embassy from Baghdad (Table 2). As in the past any escalation between Iran and the US will likely occur in Iraq. Table 2Iran Adopting Deterrence Strategy In Iraq Beyond Trump’s lame duck period, if Washington looks to normalize relations with Iran, then various Iraqi and Saudi forces will try to make sure that Iraq remains independent. Iraq is the critical strategic buffer zone for Saudi Arabia and it will use its leverage with Sunni forces inside Iraq to oppose Iranian domination and warn the US against giving too much to Iran. The problem for Iraq is that the US is divesting from the region and Biden will focus on the Iranian deal to the neglect of other issues. As a result the Saudis will escalate their influence campaign and Iraq will remain unstable. Bottom Line: Iraq is ground zero for the creation of a new regional power equilibrium. If the US manages to secure its allies, even while reviving the Iranian deal, then Iraq has a prospect of stabilization. But the insecurity of US allies will predominate so Iraq remains at risk of instability, militancy, and oil supply disruptions. A New Dawn? Unification to counter Iran is the chief motive behind the Abraham Peace Accords signed between Israel and the UAE, Bahrain, and Sudan with the Trump administration’s mediation (Table 3). Table 3The Abraham Accords Unify Iran’s Regional Rivals Although Israel and the UAE had already been cooperating and sharing intelligence, the deal creates a formal diplomatic partnership against Iran that the countries will need even more as the US pivots to Asia. From Washington’s perspective, the deal enables it to reduce its direct management of the region and delegate authority to its ally and partners. While Saudi Arabia did not sign a deal with Israel, it has signaled a change in strategy. Bahrain is ultimately a Saudi proxy and would not have signed the agreement without Riyadh’s blessing. Moreover, the decision to open Saudi airspace to Israeli airplanes highlights closer cooperation. Additional motives that helped seal the deal: President Trump sought a foreign policy win ahead of the election. The deal reflects his promise to withdraw from the Middle East. Having won 48% of the popular vote, Trump’s approach will loom large over the Republican Party. Israeli Prime Minister Benjamin Netanyahu hoped the deal would secure him a political win amid unpopularity at home. Israel was not even forced to accede to the UAE’s demand to halt the annexation of the West Bank: Netanyahu merely announced that annexation was postponed. And on October 14, only a month after the accords were signed, Israel approved new settler homes in the occupied West Bank. For the UAE, the deal requires little effort but is economically and militarily beneficial. It improves its chances of purchasing long-sought F-35 fighter jets from the US. It is also consequential that the UAE was the first to sign the deal. Abu Dhabi is seeking to raise its stature as a regional power. It has engaged in various Middle Eastern conflicts including in Libya and Yemen and is the only Arab state to have committed troops to Afghanistan for security and humanitarian missions. The UAE has also expanded its influence by being the top source of capex investments in the region (Chart 6). It has emerged as a model Arab state and seeks to replicate that success in its geopolitical status (Chart 7). Chart 6UAE The Top Mideast Investor Ultimately the Abraham Accords reflect a shift in Middle Eastern politics to address the US’s withdrawal and changing landscape. The deal’s signatories seek to improve ties not only to face Iran but also to face Turkey, Russia, and even China. Chart 7UAE Leads The Pack Opinion polls suggest that young Arabs’ favorable perception of the US are linked to its involvement in the region. Their perception of the US as an ally, or somewhat of an ally, increased post-2018 when President Trump initiated his maximum pressure campaign on Iran (Chart 8). Chart 8US Image Has Bottomed Among Arab Youth The Abraham Accords are also significant in that they mark a departure from the Arab Peace Initiative. The Initiative conditions normalization of Arab relations with Israel on Israeli withdrawal from the West Bank, Gaza Strip, Golan Heights, and Lebanon. Until recently, this initiative was a hallmark of regional diplomacy. Palestinians of course have rejected the Abraham Accords and expressed dismay at what they perceive to be disloyalty. Their sidelining could result in an increase in radicalism and militant activity in Israel, though Biden’s election will now blunt that effect and put new demands on Israel. Similarly, Turkey and Qatar oppose the agreement. The rift will widen between the authoritarian states (the GCC and Egypt) and those in favor of political Islam (Turkey and Qatar). Unlike Israel’s previous peace treaties with Egypt and Jordan, which did not result in any economic gains, bilateral economic cooperation is a cornerstone of the Abraham Accords (Table 4). Thus the agreement not only explicitly aligns geopolitical positions in the Middle East, it also weaves Israel into the region’s economies, generating gains for all sides and cementing the partnership. This is a positive example of Trump’s transactional approach to foreign policy. Table 4The Abraham Accords By Sector Bottom Line: The Abraham Accords reflect long-developing structural changes in the Middle East. With the US reducing its direct management in the region, Israel and the Arab states are drawing together – particularly in opposition to Iran. If Biden restores the Iranian nuclear deal, there may be a semblance of balance in the region. But its durability will depend on the uncertain willingness of the US to keep the peace. Great Power Struggle Instability stemming from Washington’s shift away from the Middle East is being exacerbated by the competition by great powers and middle powers over filling the power vacuum. Russian and Turkish interference has had mixed results. Both are exerting their influence through greater military engagement in Syria and Libya, in which they have partially stabilized these countries. For instance, Moscow’s 2015 decision to send its air force and some ground troops to Syria reversed President Bashar al-Assad’s fate in Syria, giving him new life. Similarly, Ankara’s increased involvement in the Libyan crisis earlier this year helped the Tripoli-based government drive General Khalifa Haftar’s Libyan National Army back to its eastern enclave. Chart 9AChina Pivots To Middle East Yet Russia’s commitment is deliberately limited and likely to become more limited due to increasing domestic political risks. Turkey’s ruling Justice and Development Party has been in power for two decades, is showing economic and political weakness, and is overreaching in international conflicts. Therefore these countries’ interventions do not have a high degree of staying power or predictability. A more durable trend is China’s growing influence in the region. China’s approach emphasizes soft power rather than hard power, but the latter will gradually come into play. China’s main motive is to secure oil supplies. It has emerged as the top oil importer, 46% of which are sourced from the Middle East (Charts 9A and 9B). Chinese interest in the region is evident in its “Comprehensive Strategic Partnerships” (the highest of China’s diplomatic levels) with several key regional actors (Table 5).   Chart 9BChina’s Mideast Dependency Grows Rather than interfering in regional politics, China has favored economic cooperation. It has emerged as a top foreign investor in the Arab region (Chart 10 and see Chart 16 below). Table 5China Cultivates Mideast Relations Chart 10Awaiting Return Of Chinese Investment This approach has been well received by the Arab population, at least the younger generations. The Arab youth see China the most favorably among all the competing foreign actors (Chart 11). Chart 11Arab Youth Have Positive Views Of China However, China is also becoming more scrutinizing of its investments in the region. The Belt and Road Initiative is no longer just a blank check. Beijing’s investments are starting to pick up and will continue to revive as its economy recovers in the coming years, but Middle Eastern states will not be able to assume they have China’s unconditional support (Chart 12). Chart 12China's Investment Just Starting To Revive, At Best While China has improved relations with Saudi Arabia and the GCC during the Trump administration’s conflict with Iran, Biden raises the possibility of China reviving its interest in Iran, which is a key linchpin of its Belt and Road Initiative and other strategies of deepening economic relations across Eurasia. Gradually China will take a more obtrusive role. It built its first overseas military base in Djibouti in 2017. Moreover, the strategic pact with Iran it is negotiating, which is likely to be very large even if lower than the official price tag of $400 billion over 25 years, also includes military cooperation. If US-China tensions persist at today’s high levels, China will try to improve its supply security in the Middle East, which will eventually become another front in the new cold war. Bottom Line: The power vacuum left by the US’s reduced commitment to the region has not been filled by any of the major or middle powers. Russian, Chinese, and Turkish actions are unclear and in some cases contradictory. China has the potential to fill in some of the vacuum, but at the moment Chinese strategic involvement is nascent. Détente between the US and Iran clears the way for China to revive relations with Iran, a linchpin of its global, regional, and Eurasian strategy. Economic Progress … Interrupted While these cyclical and structural geopolitical shifts play out, Middle Eastern states also find themselves in a weak economic situation. The double whammy of pandemic and the collapse in oil prices is weighing on household, corporate, and government budgets. It is exposing long-standing vulnerabilities, unwinding recent progress, and introducing new challenges. Arab petro-states face a funding gap in the midst of economic contraction. With oil prices significantly below those needed to balance their budgets, they are re-prioritizing their spending (Chart 13). Chart 13Fiscal Squeeze Hits Arab Petro-States While this adjustment has come at the expense of strategic economic plans, in some cases it has also led to an acceleration of fiscal reforms. Oman and Saudi Arabia are cases in point. Oman has been implementing a 5% value-added tax (VAT) since April and plans to impose taxes on high-income earners beginning 2022. Similarly, Saudi Arabia tripled its VAT from 5% to 15%, eliminated a bonus cost-of-living allowance previously granted to public sector employees, and increased custom duties for several imported goods. The immediate aim of these measures is to offset some of the weakness in oil revenues (Chart 14). But over the long run they align with the strategic objective of transitioning from resource-dependent rentier states to economically diverse ones. While the economic shock has weighed on both household and government budgets, the GCC oil producers generally enjoy low debt-to-GDP ratios and comfortable government coffers. They are better positioned than their neighbors to survive the downturn without it morphing into a social, political, or economic crisis. Oil-importing Arab states, on the other hand, face limited fiscal space and have been forced to walk back recent structural reform progress while limiting their fiscal response to the recession (Chart 15). Egypt is highly dependent on tourism and remittances from Arab petro-states. The recession has reversed the improvement in its fiscal situation following austerity measures imposed as part of the three year IMF program. Chart 14Fiscal Reforms Underway Chart 15More Stimulus Needed That said, as long as nominal GDP outpaces interest on the debt, these countries will avoid a debt crisis. Although Egypt’s 10-year yield is 14.8%, its expected nominal GDP growth of 19.7% this year will ensure debt sustainability. By contrast, Tunisia is more at risk, as the yield on its 10-year government bond is near 10% yet nominal growth lags in the single digits. While policymakers across the region have implemented measures to ease burdens on households through various policies, Gulf Arab states have in some cases limited the benefits to nationals. For instance, the Qatari government announced on June 1 that it would reduce non-Qatari employee wage bills by 30%. While this protects the incomes of GCC nationals, it puts non-nationals at risk of income loss, raising the possibility that weakness among oil-producers will be transferred to non-oil producers. Chart 16Iran Teetering On Edge This is not to say that GCC nationals are completely immune to income or employment loss. In fact, the unemployment rate among Saudi nationals, which was already higher than the overall unemployment rate, jumped 2.5 pp in the second quarter to 15.5%. The Shia Crescent remains the most vulnerable neighborhood in the Middle East. Syria collapsed over the past decade, Lebanon is in the process of collapse, and Iran and Iraq are teetering (Chart 16). The IMF estimates that Iran needs oil prices at $521.2/bbl to balance its fiscal account! Weakness in Iran has spread across its sphere of influence — i.e. other predominantly Shia states and non-state actors who depend on Tehran for informal funding. Mass protests against poor economic conditions and corruption afflicted Iraq and Lebanon in the fall of 2019, forcing both governments to resign late last year. The political and economic situations have only deteriorated since. The August 4 blast at the Port of Beirut was the final straw for Lebanon which is now facing financial meltdown. Meanwhile, Iraq’s stability continues to be tested. The collapse in oil markets has weighed on government revenues as well as on the current account, which is projected to record a deficit worth 12.6% of GDP this year, following surpluses in the previous years. The good news is that the discovery of a COVID-19 vaccine points to a rebound in global economic activity over the coming 12 months. The bad news is that the virus is breaking out again and the distribution of the vaccine will take time. Eventually the combination of vaccines and additional monetary and fiscal stimulus in the developed world will alleviate some of the Middle East’s deepest strains, but it will be a rocky road. Social and political problems will escalate for some time even after the economy bottoms. Regarding the outlook for oil markets, BCA’s Commodity & Energy Strategists see the confluence of steadily improving demand, a decline in US shale-oil production, and OPEC 2.0 production management pushing oil prices higher. They forecast Brent will average $63 per barrel next year, compared to $44 per barrel at current prices, and they make a good fundamental case for oil to average between $65 - $70 per barrel over the coming five years. The latest readings from global manufacturing PMIs send bullish signals, suggesting that Middle Eastern recovery is gradually underway (Chart 17). It is the near-term that is most treacherous. Chart 17Global Rebound Not A Moment Too Soon Chart 18New Lockdowns Pose Near-Term Risks On the demand-side, COVID-19 cases globally are trending upward with several European countries imposing partial lockdowns (Chart 18). While the lockdowns are unlikely to be as severe as earlier this year, they threaten to delay the recovery in oil markets. In response, the OPEC 2.0 coalition of producers, which was planning to reduce production cuts to 5.7 mm barrel per day in January (leading to higher output) may instead extend the current 7.7 mm barrel per day cuts when it meets again in December 2020. This means petro-states will need to contend with low prices and revenues for longer, while oil importers see shortfalls in remittances. Aside from risks to the oil market, the resurgence in COVID-19 cases adds further uncertainty to the expected recovery in global growth through knock-on effects on activity. Even though not all Middle Eastern countries are experiencing the second wave of the disease, governments have generally tightened stringency measures recently (Chart 19). Chart 19COVID-19 Restrictions Vary By Country Bottom Line: Middle Eastern economies have been hit hard by the double whammy of pandemic and oil price collapse. Policy responses have been measured to limit deviation from long-term goals. This is a positive for the long-term outlook. We expect improvements in the global economy and the recovery in oil markets over the coming 12 months to alleviate some of the pressure. However, risks are skewed to the downside and a protracted downturn could put to waste recent structural improvements. Countries that lie in the so-called “Shia Crescent” – Iran, Iraq, and Lebanon – are in dire need of resuscitation. Oil importers face the risk that the cyclical downturn unwinds recent economic improvements and uncovers structural vulnerabilities, weighing on the strategic outlook. Arab petro-states enjoy the most comfortable coffers. But even their economies are at risk, especially in the high-risk scenario in which oil markets do not recover anytime soon. Saudi Arabia and Oman are at a disadvantage versus Qatar in this sense given their outsized dependence on oil and higher fiscal breakeven oil price. Investment Implications Middle Eastern equity market capitalization is growing over time relative to the rest of the world (Chart 20). The region remains a reflation play, with a heavy sectoral focus on materials and financials as well as energy. Thus it stands to benefit over the long run as the global recovery gets underway. Chart 20Investors Gaining Interest In Mideast Over Time However, today is not an attractive entry point for the Middle East relative to other emerging markets. The rebalancing of oil markets, the current wave of COVID-19 before the vaccine rollout, and near-term geopolitical risks outlined above imply that the Middle East will face a period of heightened uncertainty and uninspiring equity performance. Protracted economic weakness will weigh on social stability. The oil-rich GCC is least vulnerable to popular unrest as it has the space to be generous to its citizens. But even these countries have had to cut some benefits. The pandemic will erode the social contract currently in place whereby monetary incentives are awarded to make up for the lack of political voice. The Shia Crescent is already in crisis as bouts of mass protests have been occurring in Iran, Iraq, and Lebanon for the past year. And the pandemic has derailed the economic recovery of various states that had only recently gotten back on track after the Arab Spring. Another bout of economic weakness will push people back into the streets, threatening to topple governments again (Chart 21). Chart 21Unrest Will Rise Even After Economic Bottom A good entry point into Middle Eastern equities will emerge once the global economy gets onto a better footing as the US and Iran will likely achieve a precarious balance. Geopolitics and the recession are forcing Arab states to adopt greater pragmatism in their economic and foreign policies. Reform policies are creating more diverse economies, as in the case of the UAE (Chart 22), which, unlike Saudi Arabia, is decoupling its equity performance from oil prices. Chart 22UAE About Financials, Saudi About Oil The risk to Israel, aside from politics, is that it is a tech-heavy bourse that could start to underperform neighbors like the UAE amid the likely global rotation into value stocks and cyclicals. Chart 23Israel Outperforms, But Beware Rotation To Value Israel has been outperforming the broad Middle East basket, including the UAE, and that trend looks to continue. But it does not look attractive relative to emerging markets as a whole. The risk to Israel, aside from politics, is that it is a tech-heavy bourse that could start to underperform neighbors like the UAE amid the likely global rotation into value stocks and cyclicals. Israel equity performance relative to Turkey closely tracks global growth versus value stocks (Chart 23). However, we do not recommend playing this specific pair trade. For that we would also need to see an improvement in Turkish governance. Turkey may benefit from global macro developments but its country risk will remain extreme. The recent change of central bank leadership temporarily improved Turkey’s relative performance but does not mark a fundamentally positive turning point in policy, according to BCA’s Emerging Markets Strategist Arthur Budaghyan. President Recep Erdogan is unlikely to adopt orthodox monetary policy and austerity prior to the 2022 elections. The approach of the elections, and several simultaneous foreign adventures, will keep the Turkish political risk premium elevated. Therefore the UAE provides the better long end of a value play on the Middle East.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com  

We are publishing the November issue of Charts That Matter. The key message from the charts on the following pages is that investor sentiment on global growth is elevated and the reflation trade is a bit overstretched. As a result, risk assets and commodities prices will likely correct, and the US dollar will rebound. Investors should keep dry powder to buy EM assets at a better entry point. A trigger for a selloff could be one or a combination of the following: the lack of a large US fiscal stimulus package, falling activity in Europe, peak stimulus in China or the recent jitter in the Chinese onshore corporate bond market. CHART OF THE WEEKThe Global Stock-To-Bond Ratio Is At A Critical Juncture US Equity Sentiment Is Elevated US equity sentiment is somewhat elevated and is consistent with a correction in share prices. Chart 1US Equity Sentiment Is Elevated Chart 2US Equity Sentiment Is Elevated   Peak Growth Sentiment Investors are quite optimistic on global growth. A record large net long positions in copper corroborate a very bullish investor stance on China/EM growth. From a contrarian perspective, this heralds a correction in commodities prices and EM as well as a rebound in the US dollar. Chart 3Peak Growth Sentiment Chart 4Peak Growth Sentiment   Defensive Versus Cyclical Equity Segments Defensive sectors/markets have been underperforming and are oversold. Their outperformance is likely in the near term. Chart 5Defensive Versus Cyclical Equity Segments Chart 6Defensive Versus Cyclical Equity Segments   Near-Term Risks To Industrial Metal Prices The Baltic Dry index is falling and iron ore prices have relapsed. This is consistent with diminishing Chinese imports of iron ore. However, iron ore inventories in China are not excessive, so odds are it is a correction and not a bear market in iron ore prices.  Chart 7Near-Term Risks To Industrial Metal Prices Chart 8Near-Term Risks To Industrial Metal Prices   Chart 9Near-Term Risks To Industrial Metal Prices Chinese Imports Of Commodities Are At Risk From Destocking  Starting April-May, Chinese imports of copper and other commodities was running at very high rates, exceeding any reasonable estimates of final demand. This suggests China has been accumulating commodities. Even as final demand continues recovering, China might diminish imports of commodities weighing on their prices in the near term. Chart 10Chinese Imports Of Commodities Are At Risk From Destocking Chart 11Chinese Imports Of Commodities Are At Risk From Destocking   Oil Prices, Energy Stocks And Glencore Share Price Oil prices and energy stocks are facing a technical resistance. Yet, the share price of the world’s largest global commodity trader – Glencore – seems to be breaking out. The coming weeks will reveal which way the commodities complex will trade. Our bias is that a near-term correction is overdue. The US dollar holds the key, please refer to the next page. Chart 12Oil Prices, Energy Stocks And Glencore Share Price Chart 13Oil Prices, Energy Stocks And Glencore Share Price   Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound US inflation expectations – which have risen sharply since March – are likely to retreat as the US Senate does not approve a large fiscal stimulus package. Falling US inflation expectations will translate into higher TIPS yields. The latter and very bearish sentiment/positioning on the US dollar will trigger a rebound in the greenback. Chart 14Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Chart 15Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar ReboundChart 16Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound   US Elections And The US Dollar: Is 2020 The Opposite Of 2016? After the 2016 US elections, the US dollar rallied strongly for several weeks and then it sold off considerably. It seems the broad trade-weighted dollar is following a reverse pattern now.  It was selling off before the 2020 US elections and has continued weakening afterwards. If the reverse of the 2016 pattern persists, it means the US dollar is about make a major bottom and stage a playable rebound. Chart 17US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 18US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 19US Elections And The US Dollar: Is 2020 The Opposite Of 2016?   More Reasons To Expect A US Dollar Rebound The periods when US share prices outperform their global peers in local currency terms often coincide with strength in the US dollar. Recently, this relationship has broken down. The greenback might soon recouple to the upside, re-establishing this relationship (Chart 21). Besides, the broad trade-weighted dollar is very oversold (Chart 22). Chart 20More Reasons To Expect A US Dollar Rebound Chart 21More Reasons To Expect A US Dollar Rebound   Rising Real US Yields And Growth Stocks Rising US TIPS yields could create headwinds for growth stocks. FAANG and Tencent share prices have risen about 20-fold since January 2010 – as much as the Nasdaq 100 did in the 1990s before topping out. Chart 22Rising Real US Yields And Growth Stocks Chart 23Rising Real US Yields And Growth Stocks   Drivers Of EM Corporate And Sovereign Credit Spreads EM corporate and sovereign credit spreads are driven by EM exchange rates and commodities prices. A potential US dollar rebound and a correction in commodities prices warrant near-term caution on EM credit markets. Chart 24Drivers Of EM Corporate And Sovereign Credit Spreads Chart 25Drivers Of EM Corporate And Sovereign Credit Spreads Messages From Indicators And Chart Patterns Various indicators and technical chart configurations send mixed signals. Our bias is to expect a correction in risk assets in the near term.  Chart 26Messages From Indicators And Chart Patterns Chart 27Messages From Indicators And Chart Patterns   Chart 28Messages From Indicators And Chart Patterns Chart 29Messages From Indicators And Chart Patterns   Peak Stimulus In China Fiscal stimulus is running out. In addition, the PBoC has been tightening liquidity in the interbank market and interest rates have risen. Banks’ loan approvals have rolled over. All these point to a peak in the credit and fiscal impulse as well as money impulses in Q4 2020. Does it mean China’s economy is about to decelerate? – refer to the next page. Chart 30Peak Stimulus In ChinaChart 31Peak Stimulus In China Chart 32Peak Stimulus In China   China: Business Cycle Expansion To Continue In H1 2021 Our credit and fiscal spending impulse points to a continuous expansion in the Chinese economy for now. If the credit and fiscal impulse rolls over in Q4 2020, as shown in the previous page, the business cycle in China will peak around middle of 2021 given the nine-month time lag between this impulse and economic data. Chart 33China: Business Cycle Expansion To Continue in H1 2021Chart 35China: Business Cycle Expansion To Continue in H1 2021 Chart 34China: Business Cycle Expansion To Continue in H1 2021   Stress In The Chinese Onshore Corporate Bond Market The recent defaults by several SOEs on their bond payments have led to a spike in corporate bond yields. However, there is no stable historical relationship between onshore corporate bond yields and the A-share market. Chart 36Stress In The Chinese Onshore Corporate Bond Market Chart 37Stress In The Chinese Onshore Corporate Bond Market   Chart 38Stress In The Chinese Onshore Corporate Bond Market China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? During periods of rising onshore corporate bond yields, the MSCI ex-TMT Investable equity index rallied if Chinese EPS expectations where improving. The latest rollover in EPS growth expectations amid rising corporate bond yields is a warning to share prices. Chart 39China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? Chinese And EM Equity Relative Performance Versus Global Stocks China’s outperformance versus global stocks has been due to its TMT stocks (Alibaba, Tencent and Meituan). In turn, excluding Chinese stocks, EM ex-China has not really outperformed the global equity index. Chart 40Chinese And EM Equity Relative Performance Versus Global Stocks Chart 41Chinese And EM Equity Relative Performance Versus Global Stocks Various EM Equity Indexes Till very recent (before the announcement of progress in vaccines), EM small caps, the equal-weighted index, EM ex-TMT stocks and the EM index ex-China, Korea and Taiwan had been lackluster. Will the latest spike persist? It depends on the S&P500 and global risk asset performance. Chart 42Various EM Equity Indexes Chart 43Various EM Equity Indexes   Chart 44Various EM Equity Indexes Chart 45Various EM Equity Indexes   Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia’s and overall EM relative performance versus global stocks is unlikely to break out now. We continue recommending a neutral allocation to EM equities in a global equity portfolio. Chart 46Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 47Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Chart 48Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 49Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Sell stocks and wait on the side lines if the 10-year T-bond yield rises by 0.3 percent. Go aggressively overweight T-bonds on any modest rise in yields. New recommendation: Go overweight healthcare versus technology on a 6-12-month investment horizon. New recommendation: Go overweight Europe versus Emerging Markets on a 6-12-month investment horizon. Fractal trade: Fractal analysis supports the decision to go overweight healthcare versus technology. Feature Since early 2018, a rise in the long bond yield has sent shudders through the stock market on four occasions: February 2018, October 2018, April 2019, and January 2020. On all four occasions, the tipping point was the earnings yield premium on tech stocks versus the 10-year T-bond yield falling towards its lower limit of 2.5 percent (Chart of the Week). Chart of the WeekSell Stocks If The Bond Yield Rises By 0.3 Percent Today, this all-important yield premium stands at 2.8 percent. Meaning that it would take the 10-year T-bond yield to rise by just 30 basis points to retest this four times tipping point. Alternatively, with the T-bond yield unchanged, the tipping point would be retested if tech stocks rallied by around 10 percent. The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Crucially, this means that the stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. We recommend selling stocks and waiting on the side lines if the earnings yield gap on tech stocks versus the T-bond yield approaches its lower limit of 2.5 percent – from any combination of moderately higher bond yields or higher stock prices over the coming weeks. Record Low Bond Yields Have Lifted The Stock Market To An All-Time High   ‘A once-in-a-century global pandemic lifts the world stock market to an all-time high’ sounds like an obscene headline. Yet this is the correct narrative for 2020. Yes, the European stock market is still languishing 10 percent below its mid-February peak. But the much larger and tech-heavy US stock market stands 10 percent higher, taking the world market to around 5 percent higher (Chart I-2). How can the aggregate market stand at an all-time high when a terrible plague continues to ravage the global economy? The simple answer: because of record low bond yields. Chart I-2Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Back on February 27, we wrote: “for stock markets, the best inoculation against Covid-19 is ultra-low bond yields.” And so it proved. Though stock market profits are down by 15 percent this year, the multiple paid for those profits is up by 20 percent, resulting in a 5 percent uplift in the market price (Chart I-3). Chart I-3Valuations, Not Profits, Are Driving The Stock Market Specifically, tech sector valuations have become hyper-sensitive to any change in the long bond yield (Chart I-4). Meaning that for those stock markets with a high weighting to tech stocks, the valuation boost from a decline in bond yields has more than countered the profit slump from the pandemic. In fact, the pivotal role of bond yields precedes the pandemic. For the past three years, a good motto for investors has been: don’t focus on profits, focus on valuations. Chart I-4Valuations, Not Profits, Are Driving The Tech Sector The Biggest Threat To The Stock Market Is Higher Bond Yields   Through 2018-19, stock market profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018 then surged in 2019. In 2020, as the pandemic devastated profits, a further surge in the multiple immunised the stock market against the ravages of Covid-19. The dramatic swing in multiples was driven by the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing long-duration bonds. But at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the scope for further price rises diminishes while the scope for price collapses increases. For proof, just look at Swiss 10-year bonds. Their prices can barely rise anymore! Yet they can fall precipitously (Chart I-5). In short, the lower that bond yields go, the riskier that bonds become as an investment. Chart I-5Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot As bonds become a riskier investment, the excess return on equities versus bonds, the equity risk premium (ERP), collapses towards zero. After all, if the riskiness of equities and bonds converges, then any risk premium must disappear. The result is that the prospective return (discount rate) required on equities declines exponentially, because both of its components – the bond yield plus the ERP – decline in tandem. Given that valuation is just the inverse of the discount rate, the valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Conversely, the valuation of equities falls exponentially when the bond yield rises from an ultra-low level. The valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Yet doesn’t a higher bond yield also imply a higher nominal growth rate for profits, which should be good for the stock market? Yes, but understand that the increase in the discount rate (nominal bond yield plus ERP) will be much larger than the increase in the profit growth rate. The result is a plunge in the stock market’s net present value. Once you grasp this exponential relationship, the penny suddenly drops. The pandemic has proved that the biggest structural threat to the stock market does not come from a negative growth shock like a once-in-a-century global plague. The pandemic has been good for the aggregate stock market because it has forced bond yields to decline to ultra-low levels. Instead, the biggest threat to the stock market is higher bond yields. Please note that this disagrees with the BCA house view – which does not preclude stocks from rising even if yields rise by 0.3 percent, if this takes place against the backdrop of better growth prospects. Sell Stocks If The Bond Yield Rises By 0.3 Percent As the first chart powerfully illustrates, higher bond yields sent shudders through the stock market on four occasions in the past three years. We are close to a similar near-term valuation test. Of course, given enough time, a gradual rise in earnings can lift the tech earnings yield gap versus the bond yield to well above its danger level of 2.5 percent. However, over shorter periods, it would require stock prices and/or bond yields to stop rising. Or indeed, to reverse. For equities, the upshot is that the 60 percent rally since mid-March is reaching near-term exhaustion. We recommend selling stocks and waiting on the side lines if the 10-year T-bond yield was to rise by another 30 bps. For bonds, the upshot is that all else being equal, 10-year bond yields can rise by no more than 30 basis points before sending shudders through the stock market. Which would then cause bond yields to give back their gains, as they did on each of the four previous occasions that higher bond yields spooked the stock market. On this basis, it is not worth underweighting bonds. The much smarter strategy is to go aggressively overweight T-bonds on any modest rise in yields. Within equity sectors, there are three arguments in favour of healthcare. First, while the tech sector earnings yield gap versus the T-bond yield is approaching its lower limit of 2.5 percent, the healthcare sector earnings yield gap stands at a very comfortable and attractive 4.1 percent, well above its recent lower limit of 2.0 percent (Chart I-6). Second, unlike tech, the healthcare sector rally is being driven by profits, not by a valuation uplift (Chart I-7). Third, fractal analysis confirms that the massive underperformance of healthcare versus technology is reaching technical exhaustion (see last section). Chart I-6Healthcare's Earnings Yield Premium Looks Very Attractive Chart I-7Profits, Not Valuation, Are Driving The Healthcare Sector Hence, today we are recommending that on a 6-12-month horizon, equity investors should go overweight healthcare versus technology.  Go Overweight Europe Versus Emerging Markets Finally, sector strategy has huge implications for regional and country allocation. Given that the European stock market is overweight healthcare and emerging markets (EM) is overweight technology, the decision to overweight Europe versus EM is simply the decision to overweight healthcare versus technology. Nothing more, and nothing less (Chart I-8). Chart I-8Europe Versus EM = Healthcare Versus Tech Hence, today we are also recommending that on a 6-12-month horizon, equity investors go overweight Europe versus emerging markets. Fractal Trading System* Supporting the fundamental arguments for healthcare versus tech in the main body of this report, the 130-day fractal structure of relative performance is extremely fragile. This implies that the massive underperformance of healthcare versus tech is at a potential inflection point. Accordingly, this week’s recommenced trade is to go long healthcare versus technology. Set the profit target and symmetrical stop-loss at 6 percent. In other trades, we are pleased to report that long financials versus basic resources achieved its 3.5 percent profit target, and short MSCI India versus MSCI Czech Republic achieved its 8 percent profit target. The rolling 1-year win ratio now stands at 54 percent. Chart I-9 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Similar to last Monday, the SPX opened weekly trading with gusto courtesy of the MRNA’s 94% efficacy vaccine news, but failed to breach previous all-time highs. In the short-term there are high odds that the SPX will move sideways, before rallying higher, in order to digest the recent up move and work off overbought conditions. According to the American Association of Individual investors (AAII), bulls are back in droves and the AAII bull/bear ratio has slingshot to the highest level since January 2018. This is cause for near-term concern as it has historically served as a reliable contrary signal (Chart 1). The knee-jerk equity market reaction on the back of the positive vaccine news has also pushed the percentage of SPX stocks trading above their 200-day moving average to a zenith, warning that the SPX will most likely move laterally (Chart 2). Chart 1 Chart 2   Bottom Line: We remain cyclically and structurally bullish, but in the shorter-term, chances are that the SPX will take a breather. For more details, please refer to this Monday’s Weekly Report.

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns