Geopolitics
BCA Research's Global ETF Strategy service concludes that a resurgence of geopolitical uncertainty casts a shadow on the short-term outlook for risk assets’ continued recovery. Our Geopolitical Strategy team highlights that equity volatility always tends to…
Dear Client, In lieu of our regular report next week, I will present our view on China’s economic recovery, geopolitical risks, and implications on financial markets in two live webcasts. The webcasts will take place next Wednesday, July 15 at 10:00AM EDT (English) and at 9:00PM EDT (Mandarin). Best regards, Jing Sima, China Strategist Highlights China’s economic recovery continues through June, but the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009. The intensity of the PBoC’s monetary easing may start to taper in H2, but the central bank is likely to stay on the easing course and keep liquidity conditions ample. Bank lending to the corporate sector should increase further in H2. Chinese stocks rallied through last week’s enactment of the new national security law for Hong Kong and the subsequently announced sanctions from the US government. The existing US sanctions should have limited impact on Hong Kong and mainland China’s economies and financial markets. We remain positive on Chinese stocks despite the recent rallies in China’s equity markets. Feature June’s official and Caixin manufacturing PMIs indicate that China’s economic recovery continues at a steady rate, with the production side of the economy picking up slightly faster than the demand side. The drag on China’s economic recovery from lackluster demand growth should be temporary. Unlike in 2015 when policy uncertainties hindered the recovery in both economic activity and stock prices, the Chinese government has been determined to support its economy and job market in the current cycle. The massive stimulus implemented since March has tremendously boosted activities in China’s construction sector. While households and the corporate sector remain reluctant to spend and to invest, their marginal propensity to spend usually catches up with credit growth with about a 6-9-month lag (Chart 1). The sharp pickup in credit growth should meaningfully support China’s economic rebound, while a better global growth outlook in H2 should also provide some modest tailwinds. On June 30, the PBoC announced a 0.25 percentage point cut to its relending rates for small and rural enterprises and to its general rediscount rate. While the scale of rate cuts in H2 will unlikely match that of Q1, China’s monetary and fiscal policy support will remain in place through the rest of the year. Chinese investable and domestic equities were some of the best performers among global asset classes in June, whereas they were the third-worst the month prior (Chart 2). In the first week of July, both Chinese investable and domestic stocks rallied even further. As we noted in our last week’s report,1 China’s stronger economic outlook, less uncertainty related to its domestic COVID-19 containment, and policy support should provide more room for Chinese stocks to trend upwards. Last week’s passing of the new national security law for Hong Kong and the subsequently announced sanctions from the US government, in our view, should have limited impact on investors’ sentiment for now. Chart 1China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months Chart 2Chinese Equities Are Taking Flight Tables 1 and 2 present key developments in China’s economic and financial market performance in the past month, and we highlight several of these developments below: Table 1China Macro Data Summary Table 2China Financial Market Performance Summary China’s June official manufacturing PMI ticked up to 50.9 from 50.6 in the previous month. The Caixin manufacturing PMI came in at 51.2, beating the expectation of 50.5 and compared to 50.7 in May. Both suggest that China’s manufacturing sector continues to expand, however the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009 (Chart 3). Although the import and export subcomponents have fared better in June from the low levels in April and May, their readings in June were still below the 50 boom-bust line (Chart 4). Headwinds remain strong for global trade as the US and many of emerging economies are still struggling with the pandemic. Even without re-imposing lockdowns, the resurge in the number of new cases in the US may result in a drag on consumption and global trade. The IMF projects a 12% contraction in global trade in 2020. While the external demand may improve in H2, positive contribution to China's GDP growth from the net exports will be limited this year. Chart 3Current Recovery Lies Somewhere Between 2009 And 2015 Chart 4Demand-Side Recovery Remains Muted The employment situation in the manufacturing sector has worsened since May, and has returned to contraction following a brief improvement in March and April (Chart 5). An estimated 8.7 million new graduates in 2020,2 a historical high number, will hit the job market in July and August. As such, China’s labor market will likely remain under significant pressure. Even though employment usually lags economic recoveries, depressed expectations on the job market will refrain policymakers from prematurely withdrawing stimulus measures. Small and micro enterprises are an important part of China’s private sector, which provides 80% of jobs in China. The manufacturing PMI of small enterprises fell below the 50 boom-bust line in June, reflecting a persistent weakness in this part of China’s economy. The recent relending and rediscount rate cuts suggest that the PBoC is committed to stay on the easing course. The intensity of monetary easing may start to taper in H2, but the central bank is likely to keep liquidity conditions ample and encourage banks to accelerate lending to the corporate sector. The contraction in Chinese producer prices deepened to -3.7% (year-over-year) in May. However, we think PPI deflation is likely to bottom in Q3. Both the purchasing and producer price subcomponents of the manufacturing PMI ticked up sharply in June, while the drawdown in industrial product inventory relative to new orders has accelerated (Chart 6). The ongoing accommodative policy should provide powerful tailwinds to both economic activity and the PPI in H2. The improvement in the PPI will help to boost industrial profits growth, which turned positive in May (year-over-year) for the first time this year. We expect year-to-date industrial profits to end the calendar year with a modest positive growth rate. Chart 5Labor Market Pressure Intensifies Chart 6PPI Deflation Nears Its Bottom China’s property market indicators have notably trended up in May, with year-over-year growth in housing demand normalizing to its pre-pandemic level (Chart 7A & Chart 7B). As the demand in housing rebounded faster than the supply, housing prices have correspondingly turned the corner in May after trending down for 6 consecutive months. Chart 7AHousing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Chart 7BStrong Rebound In Property Investments Chart 7B shows that housing investments and land purchases have also recovered to near their pre-pandemic levels. Financing restrictions for property developers that were put in place since 2018 have been loosened in H1, which helped to boost real estate investments. We expect the property sector financing conditions to remain accommodative through the rest of this year. Moreover, there is a possibility that the PBoC will lower the 5-year MLF (medium lending facility) rate in Q3. As downward pressures on China's labor market and household income growth intensify, the government is likely to lower the mortgage rate to ease payment constraints on households. Chart 8Chinese Stocks Rallied Through Frictions Over Hong Kong Despite the passing of China’s new and controversial national security law for Hong Kong on June 30 and the subsequently announced sanctions from the US government, stock prices in both China’s onshore and offshore markets rallied (Chart 8). While we agree the US may impose further and more concrete sanctions on China during the months leading up to the November US presidential election, our preliminary assessment points to a limited economic cost on China from the existing US sanctions. The removal of Hong Kong’s special trade status will subject Hong Kong’s export goods to the same tariffs the US levies on Chinese exports. But the raised tariffs will barely make a dent in Hong Kong or mainland China’s export status quo. Hong Kong’s economy consists mainly of the financial, logistical and services sectors. The manufacturing sector only accounts for 1% of its overall economy. Chart 9 shows that Hong Kong’s exports to the US only accounted for around 1% of its total exports and 1.3% of its GDP in 2019. More importantly, of the $5 billion goods Hong Kong exports to the US, only 10% is actually produced in Hong Kong. Most of Hong Kong's exports to the US are goods produced in China that are re-exported through Hong Kong, which are already subject to the same tariffs as the goods China exports to the US directly.3 On the other hand, US exports to Hong Kong accounts for 2% of its total exports, with a trade surplus of about $30 billion in the past two years (Chart 9, bottom panel). The US trade surplus with Hong Kong has drastically reduced since the US-China trade war broke out in 2018, suggesting that the US has already imposed restrictions on its export goods to mainland China through Hong Kong. Moreover, the large trade surplus with Hong Kong as well as China’s commitment to the Phase One trade deal may be part of the reason President Trump is unwilling to impose more substantial sanctions on China right now. The US senate and house have also passed a bill which, if signed and implemented by President Trump, will allow the US government to levy any foreign financial institutions for knowingly conducting business with individuals who are involved in jeopardizing Hong Kong’s autonomy. Chinese banks with operations in the US will be mostly exposed to such sanctions. However, Chinese banks are largely domestic-focused with very low reliance on foreign-currency funding (Chart 10). Hence, the direct impact of a deteriorating operating environment in the US will be limited on Chinese banks. Chart 9Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Chart 10Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report "Upgrading Chinese Stocks To Overweight," dated July 1, 2020, available at cis.bcaresearch.com 2 iiMediaReport, Analysis report on current situation and development trend of Chinese employment entrepreneurship market in 2020. 3 Please see Nicholas Lardy, “Trump’s latest move on Hong Kong is bluster”. Peterson Institute For International Economies, dated June 1, 2020. Cyclical Investment Stance Equity Sector Recommendations
Investors do not need to wait for the US election verdict to assess the general trajectory of US-Russia relations, according to a Special Report released on Friday by BCA Research’s Geopolitical Strategy and Emerging Markets Strategy services. Whether…
Highlights A clear U-turn in markets could make investors more conscious of losses, making them likely to sell. Hence, the fear-of-missing-out (FOMO) rally could turn into a fear-of-losing-out, or FOLO selloff. The P/E ratio is negatively correlated to the discount rate and the latter is the sum of the risk-free rate and the equity risk premium (ERP). Enormous lingering uncertainty warrants using an ERP that is at the upper end of its historical range. By using the average equity risk premium in their equity valuation models, investors are underpricing risks that are presently exceptionally high. Several market-based indicators and technical configurations point to a relapse in the global equity rally and renewed US dollar strength. Feature For some time, we have been arguing that the global equity advance since late March can best be described as a fear-of-missing-out, or FOMO, rally. During a FOMO rally, investors are forced to chase share prices higher due to fear of missing out on gains. A clear U-turn in markets and falling share prices could make investors more conscious of losses, and they would likely resort to selling stocks. This will turn the FOMO rally into a fear-of-losing-out, or FOLO, selloff. Marginal investors trade with momentum during both FOMO and FOLO scenarios. This is why we argued in our June 18 note that current investment strategies should be placing more emphasis on momentum than would normally be the case. In a nutshell, if FOMO forces subside, investors – which are facing enormous uncertainty on several fronts – will likely require higher risk premiums to commit money to stocks. For now, the momentum of the equity rally has stalled, but it has not yet reversed (Chart I-1). Our momentum indicator for global share prices is struggling to break above the zero line. In the past, the indicator being above or below zero often differentiated bull versus bear markets, respectively (Chart I-1, bottom panel). Chart I-1Global Share Prices Are Facing An Important Resistance In this report, we examine the bullish narrative behind the rally and offer our interpretation of those arguments. Then, we present our assessment of the fundamentals. Finally, we highlight the signs we are looking for to confirm that a major selloff will soon occur. The Bull Case: Climbing A Wall Of Worries? The bull case rests on the thesis that risk assets are climbing a wall of worries, i.e., investors are correct to look through many apparent negatives. The following are the key bullish arguments that have supported the rally: Policymakers around the world will do whatever it takes. The US, China and Europe will continue to augment stimulus to prevent another relapse in economic activity. We have never doubted the willingness of policymakers around the world to provide stimulus to their economies amid the pandemic. Where we have had reservations and questions is in whether policymakers will be capable of limiting the bear market in stocks to only one month amid the pandemic and the worst global recession in decades. There is plenty of cash on the sidelines looking to be invested. We agree with the lots-of-cash-on-the-sidelines thesis. Our measure of US dollar cash that might be deployed in financial assets is illustrated in Chart I-2. It plots the ratio of the US broad money supply to the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US dollar-denominated stocks and all types of bonds held by non-bank investors. If the market shows resilience and the pandemic situation and corporate profits ameliorate, cash on the sidelines will leak into assets, lifting their prices. The counterargument is as follows: If and when the equity momentum reverses, FOMO will be followed by a FOLO phase. In such a case, investors will sell to avoid losses or protect profits, and cash on the sidelines might not matter for a period of time. The global economy reached a bottom in April-May. We agree that the worst of the contraction in economic activity globally was in April and May, when major economies were in lockdown. Nevertheless, it is also plausible that global share prices could relapse even if the bottom in economic output has already been reached. Interestingly, in the 2001-2002 recession, global stocks made a major new low in late 2002/early 2003 even though global growth bottomed in 2001 (Chart I-3). Chart I-2The US: Broad Money Supply Relative To US Equity And Bond Markets Capitalization Chart I-3Global Stocks And The Business Cycle In 2000-2003 This recession is different from the perspective of the magnitude of the drop in business activity. Many businesses are still operating below their breakeven points and will likely continue to do so for some time. As such, a marginal increase in the level of activity or slower annual contraction might not be sufficient to enable them to service their debt and resume hiring and business investment. Therefore, the recovery will be stumbling and hesitant and relapses are quite likely, especially in the context of the ongoing pandemic. Finally, one of the pervasive arguments dominating the current investment landscape is that equities are cheap given very low interest rates. Unlike some of our colleagues, we are not in accord with this valuation thesis on global stocks in general and US equities in particular. One consideration that is missing in this argument is the equity risk premium. The P/E ratio is negatively correlated to the discount rate.1 The discount rate is the sum of the risk-free rate and the equity risk premium (ERP). Presently, one should use an ERP that is materially higher than its historical mean (Chart I-4, top panel). Investors are currently facing record-high uncertainty related to the pandemic and the business cycle, as well as the structural trends in the economic, political and geopolitical spheres. This warrants using an ERP that is at the upper end of its historical range. Chart I-4Exceptionally High Uncertainty Warrants A Higher Equity Risk Premium Critically, the ERP is not a static variable. Yet many equity valuation models assume that the ERP is constant, and therefore compare equity multiples with risk-free rates. Such models are wrong-headed because a change in the ERP can in and of itself cause large fluctuations in share prices. The bottom panel of Chart I-4 plots the US ERP and the global policy uncertainty index. The latter is at an all-time high while US ERP is well below its highs. In a nutshell, if FOMO forces subside, investors – which are facing enormous uncertainty on several fronts – will likely require higher risk premiums to commit money to stocks. Bottom Line: By using the average ERP in their equity valuation models, investors are underpricing risks that are presently exceptionally high. Bear Markets (Like Pandemics) Occur In Waves The duration and magnitude of the rally from the late-March lows admittedly has taken us by surprise. Nevertheless, it is hard to believe that the bear market associated with the worst recession and pandemic in a century was confined to only one down leg (albeit a vicious one) and lasted just one month. Just as corrections are inherent parts of bull markets, bear market rallies are an integral part of bear markets. It would be unprecedented if this bear market did not have at least one bear market rally. We do not mean EM or DM share prices will drop to new lows. Our point is that global stocks and EM currencies will likely experience a setback large enough to make investors feel that the bear market is back. Like pandemics, bear markets occur in waves. The timing, duration and magnitude of the second wave of the equity selloff is as impossible to predict as that of the second wave of COVID-19. Just as corrections are inherent parts of bull markets, bear market rallies are an integral part of bear markets. Our fundamental case for a relapse in EM equities and currencies is as follows: First, a downturn in US equities will dampen EM risk assets. The former are vulnerable due to the second wave of the pandemic that is already underway in a considerable portion of the US. Even if the second COVID-19 wave does not produce simultaneous shutdowns across the entire country, rolling lockdowns in parts of the US and lingering general uncertainty will hinder business investment and hiring. This will delay the profit recovery that the market has priced in. Second, global equities have rallied too fast and too far, as evidenced by the unprecedented gap that has opened up between stock prices and forward EPS (Chart I-5). The 12-month forward P/E ratio is 19.5 for global equities, 22.5 for the US and 14 for EM. Rising share prices amid falling projected EPS levels has been one of the key reasons behind our argument that the equity advance of the past three months has been a FOMO rally. Third, retail participation in this equity rally has been unprecedented. This has been true not only in North America but also in many Asian markets. Specifically, Chart I-6 demonstrates increased retail participation in equity markets in Korea, Thailand, and Malaysia. These are corroborated by numerous media articles such as: Amateur Traders Pile Into Asian Stocks, Making Pros Nervous Small India Investors Are Latest to Snag Beaten-Down Stocks Fear of Missing Historic Rally Has Koreans Borrowing to Invest Retail Investors Are Driving Record Turnover in Thai Stocks Singapore’s Retail Investors Load Up On What Institutions Dump Chart I-5The Global Forward P/E Ratio Is At Its Highest Since 2002 Chart I-6A Stampede By Asian Retail Investors Into Local Equities Chart I-7Oil Inventories Are Rising In The US And OECD Retail investors chasing share prices higher is another fact leading us to term this advance as a FOMO rally. If share prices relapse meaningfully, retail investors may well turn from net buyers to net sellers – i.e. FOMO will turn into FOLO. Fourth, oil prices have had a nice run, despite crude inventories in the US and OECD countries continuing to mushroom (Chart I-7). Rising inventories signify that demand remains deficient relative to supply. Hence, the oil price rally can also be qualified as a FOMO rally, driven by investors rather than demand-supply dynamics. Interestingly, global energy stocks have a higher correlation with forward oil prices rather than the spot rate. Both share prices of oil producers and three-year forward oil prices have already rolled over (Chart I-8). Finally, geopolitical tensions between the US and China are set to escalate as President Trump attempts to save his re-election campaign by rallying the nation behind the flag against foreign adversaries. China would certainly respond. As part of China’s response, North Korea will likely be “allowed” by Beijing to test a strategic weapon, undermining President Trump’s foreign policy achievements. The resulting geopolitical uncertainty will further weigh on the confidence of investors in Asian markets. Critically, share prices in north Asia – China, Korea and Taiwan – that account for 60% of the MSCI EM equity benchmark will come under selling pressure. Excluding these three bourses, EM shares prices have already rolled over (Chart I-9). Chart I-8Global Oil Stock Prices Move With Forward Oil Prices Chart I-9Diverging Equity Performance: North Asia Versus The Rest Of EM In short, the key risk to Chinese, Korean and Taiwanese stocks is geopolitics. The rest of the EM universe is suffering from the acute COVID-19 crisis and numerous economic challenges. Bottom Line: The overarching message from our fundamental analysis is that the rally in global and EM share prices has ignored many negatives and is at a risk of a meaningful relapse. Gauging The Second Selling Wave: Technical Observations Chart I-10The US Dollar And VIX Have Not Yet Broken Below Their Supports We constantly monitor numerous market indicators. We highlight below some of the most important ones that we feel are pointing to a second sell-off wave occurring sooner than later. The broad trade-weighted US dollar and the VIX index have not yet entered a bear market (Chart I-10). In fact, it seems they are finding support at their 200-day moving averages and respective horizontal lines - shown on Chart I-10. A rebound in both the trade-weighted dollar and VIX will coincide with an air pocket in global stocks. Our Risk-On/Safe-Haven Currency ratio has rolled over (Chart I-11). It correlates with EM shares prices, and points to a relapse in EM stocks. Chart I-11The Risk-On/Safe-Haven Currency Ratio Heralds A Pullback In EM Stocks Finally, credit spreads of riskier parts (CAA rated) of the US high-yield corporate bond universe have commenced widening versus the aggregate US high-yield benchmark. These relative spreads are shown inverted in Chart I-12. Chart I-12US Credit Markets Internals Point To A Relapse In US Small Cap Stocks Underperformance of riskier parts of the US corporate credit market often coincides with lower US small-cap share prices (Chart I-12). Bottom Line: Several critical market-based indicators and technical configurations point to a relapse in global equities and renewed US dollar strength. The odds of a selloff in EM share prices, currencies and credit markets are considerable. Investment Recommendations In our June 18 report, we contended that a breakout of global share prices and a breakdown in the trade-weighted US dollar would indicate that this rally might persist for a while. Conversely, a drawdown in global equities and a rebound in the greenback could be considerable. Since then, neither global stocks have broken out nor the US dollar broken down. Hence, the jury is still out. At the moment, the risk-reward profile of EM stocks remains unattractive. Within a global equity portfolio, we continue underweighting EM. Within a global credit portfolio, we are neutral on EM sovereign credit versus US corporate credit. The rationale is as follows: the low odds of public debt defaults among mainstream developing countries and the Federal Reserve’s purchases of US corporate bonds has channeled flows to EM credit, possibly precluding relative EM underperformance. We continue shorting the following basket of EM currencies versus the US dollar: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Structurally, we are also short the RMB and SAR. Finally, we continue receiving rates in Mexico, Colombia, India, China, Malaysia, Korea, Russia, Ukraine, Pakistan and Egypt. Central banks in the majority of EM countries will continue cutting rates, but we find better value in these fixed-income markets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 The P/E ratio inversely correlates to the discount rate: P/E ratio = (Payout rate x (1 + Growth rate))/ (Discount rate – Growth rate) Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
BCA Research's Geopolitical Strategy service expects the S&P 500 to trade in a range between 2800 and 3200 points during a period of limbo in which risks over the pandemic response and politics will come to the fore while the market awaits new stimulus…
Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Chart 5Trump’s Lifeline Is The Economy Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Chart 18Egypt Is Militarily Capable … On Paper Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine. Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth Chart I-7The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Chart II-2Wage Growth Is Subdued! As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months. EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes 1 Investors ignore triple crisis and bet on equities 2 Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations