Mexico

Highlights For the month of February, our trading model recommends shorting the US dollar versus the euro and Swiss franc. While we agree a barbell strategy makes sense, we would rather hold the yen and the Scandinavian currencies. In the near term, we recommend trades at the crosses, given the potential for the dollar rally to run further. An opportunity has opened up to short the AUD/MXN cross. We are tightening the stop on our short EUR/GBP position to protect profits. We believe EUR/CHF still has upside. While the US has been labelling Switzerland  a currency manipulator, the real culprit is Europe. Precious metals remain a buy. We are placing a limit sell on the gold/silver ratio at 70, after our initial target of 65 was touched. Platinum should also outperform in 2021. Remain long AUD/NZD, as the key drivers (relative terms of trade and cheap valuation) remain intact. Feature Currency markets are at a crossroads. On the one hand, news on the vaccine front continues to progress, raising the specter that we might return to normalcy sometime in the second half of this year. On the other hand, the current lockdowns are slowing down economic activity across the developed world, which is bullish for the dollar. With the DXY index up 1.4% this year, it appears near-term economic weakness is dominating the currency market narrative. Our long-term trade basket is centered on a dollar-bearish theme, but we have been shifting much focus in the near term to non-US dollar opportunities. Central to this has been our conviction that the dollar is due for a countertrend bounce, in an order of magnitude of 2%-4%.1 It appears we are already halfway there (Chart I-1). For the month of January, our trade recommendations outperformed the model allocation. Notable trades were being short gold versus silver and being short EUR/GBP. Silver in particular was a big winner in January (Chart I-2). Most emerging market currencies saw weakness, especially the Korean won, Russian ruble, and Brazilian real Chart I-1The Dollar Has Been Strong In 2021 Chart I-2Our FX Portfolio Did Well In January For the month of February, our trading model recommends shorting the US dollar, mostly versus the euro and Swiss franc (Chart I-3 and Chart I-4). The model gets its signal from three variables: Relative interest rates (both levels and rates of change), valuation, and sentiment.2 While some of these variables have moved in favor the dollar, the magnitude of these moves has not been sufficient to trigger a model shift. We agree a barbell strategy makes sense. That said, we would rather hold the yen (as the safe haven, compared to the CHF) and the Scandinavian currencies (compared to the EUR). These are our two strategic positions, and we made the case for yen long positions last week. Chart I-3Our FX Model Remains ##br##Short USD... Chart I-4...Especially Versus The Euro And Swiss Franc Circling back to our trades at the crosses, we maintain that they should continue to perform well in February and beyond. We revisit the rationale behind these trades, as well as introduce a new idea: Short the AUD/MXN cross. Go Short AUD/MXN A tactical opportunity has opened up to go short the AUD/MXN cross. Central to this thesis are three catalysts: relative economic activity, valuation, and sentiment. The Australian PMI has rebounded quite strongly relative to that in Mexico, driven by the performance of the Chinese economy, versus that of the US economy. Australia exports mostly to China, while Mexico is heavily tied to the US economy. With the Chinese credit impulse rolling over, the US economy has been outperforming of late. If past is prologue, this will herald a lower AUD/MXN exchange rate (Chart I-5). Correspondingly, oil prices are outperforming metals prices. China is the biggest consumer of metals, while the US is the biggest consumer of oil. A higher oil-to-metal ratio is negative for AUD/MXN. Terms of trade between Australia and Mexico have been an important driver of the exchange rate (Chart I-5). China had a massive restocking of metals last year, much more than oil and natural gas. This implies that the destocking phase (should it occur) will be most acute among metal inventories (Chart I-6), suggesting oil imports into China could fare better than metals. On a real effective exchange rate basis, the Aussie is expensive relative to the Mexican peso. Historically, this has heralded a lower exchange rate (Chart I-7). Chart I-5AUD/MXN And Terms Of Trade   Chart I-6Chinese Destocking: From Crude Oil To Metals? Chart I-7AUD/MXN Is ##br##Expensive Back in 2020, when everyone was short the Aussie and long the MXN, being a contrarian paid off handsomely. Now, speculators are roughly neutral both crosses. Should the trends we are highlighting carry on into the next few months, this will be a powerful catalyst for speculators to jump on the bandwagon. We recommend opening a short AUD/MXN trade today, with a stop loss at 16.50 and an initial target of 13. Stay Short EUR/GBP Chart I-8An Asymmetry In Pricing Our short EUR/GBP position is performing well, amidst a more hawkish Bank of England this week. Technically, there remains room for much downside on the cross. Real interest rates in the UK are rising relative to those in the euro area. The Brexit discount has not been fully priced out of the EUR/GBP cross, whereas broad US dollar weakness has eroded the discount in cable (Chart I-8). From a technical perspective, speculators are still very long the EUR/GBP, even though our intermediate-term indicator is nearing bombed-out levels (Chart I-9). Chart I-9EUR/GBP Still Has Downside Finally, short EUR/GBP tends to benefit from an outperformance of oil prices. We will be revisiting the fair value of the pound in upcoming reports given the fundamental shifts that are happening in the post-EU relationship. For now, we are tightening stops on our short EUR/GBP position to 0.89, in order to protect profits. Remain Long NOK And SEK Chart I-10NOK Follows Oil Prices The Scandinavian currencies are  extremely cheap and an attractive bet for 2021. As such, we believe the recent relapse in their performance provides an opportunity for fresh long positions. For the NOK, a rising oil price is bullish, both against the EUR and USD (Chart I-10). Meanwhile, superior handling of the pandemic has buoyed domestic economic data in Norway. Both retail sales and domestic inflation have been perking up, pushing the Norges Bank to dial forward expectations of a rate lift-off. Sweden is also holding up relatively well this year. Part of the reason for this is that over the years, the drop in the Swedish krona, both against the US dollar and euro, has made Sweden very competitive. With our models showing the Swedish krona as undervalued by 13% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. The bottom line is that both Norway and Sweden are well positioned  to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to remain the best performers versus the USD in the coming year.  Stay Long EUR/CHF While the US has been labelling Switzerland  a currency manipulator, the real culprit is the euro area. To be clear, the SNB has been actively intervening in the currency markets. However, when one looks at relative monetary policy, the expansion in the ECB’s balance sheet far outpaces that of the SNB (Chart I-11). With the correlation between balance sheet policy and the exchange rate shifting, it may embolden Switzerland to intervene even more strongly in currency markets. Historically, the Swiss franc was buffeted by the global environment (improving global trade) and rising productivity in Switzerland. As a result, the SNB had no alternative but to try to recycle those excess savings abroad by lifting its FX reserves, or see even stronger appreciation of its currency. With global trade much more muted, intervention in the FX market could be a more potent headwind for the franc. Chart I-11The SNB Is More Hawkish Than The ECB Chart I-12EUR/CHF And The Global Cycle In the near-term, the risk to this trade is that safe-haven flows  reaccelerate, as investors re-price risk. However, this will be a short-term hiccup. EUR/CHF is a procyclical cross and will benefit from improvement in the Eurozone economy relative to the rest of the world (Chart I-12). Meanwhile, by many measures, the Swiss franc remains expensive versus the euro. Stay Long AUD/NZD Chart I-13RBA QE Will Hurt AUD/NZD The rally in the kiwi has provided an exploitable opportunity to lean against it. We remain long the AUD/NZD cross, despite the RBA stepping up the pace of QE at its latest meeting. The rationale is as follows: The balance sheet of the RBA was already lagging that of the RBNZ, so the latest move is simply  catch up (Chart I-13). It has no doubt been negative for the cross, as Australia-New Zealand rates have compressed. However, when the program expires, the AUD will be subject to external forces once again.  The Australian bourse is heavy in cyclical stocks, notably banks and commodity plays, while the New Zealand stock market is the most defensive in the G10. Should value outperform growth, this will favor the AUD/NZD cross. The kiwi has benefited from rising terms of trade, as agricultural prices have catapulted higher. Should a correction ensue, as we expect, this will favor NZD short positions. Our conviction on long AUD/NZD has clearly been hit with the RBA’s latest move. As such, we are tightening stops to 1.05 for risk management purposes. Stay Long Precious Metals, Especially Silver And Platinum We are placing a limit sell on the gold/silver ratio at 70, after our initial 65 target was hit. The rationale for the trade remains intact: In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. However, silver has underperformed the rise in gold. The long-term mean for the gold/silver ratio is 50, providing ample alpha for this trade (Chart I-14). Chart I-14The Case For Short Gold Versus Silver Silver is heavily used in the electronics and renewable energy industries, which are capturing the new manufacturing landscape. Silver faced resistance near $30/oz. However, this will be a temporary hiccup. The next important level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange Strategy report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

Highlights Latin America faces a deep economic contraction and a new surge of social unrest and political unrest. However, the risks are increasingly priced into financial markets – especially if global monetary and fiscal stimulus continue. A looming global cyclical upturn, massive US and Chinese stimulus, a weaker dollar, and rising commodity prices will lift Latin American currencies and assets. Mexico faces lower trade risk and lower political risk. Colombia’s fundamentals are sound and political risk is contained. Chile’s political risk is significant but will benefit from the macro backdrop. Brazil will remain volatile. We are bearish on Argentina. Venezuela’s regime will be replaced before long. Our tactical positioning is defensive on COVID-19 and US political risk, but we see Latin America as an opportunity over the long run. Feature Cracks in the edifice of this year’s global stock market recovery are emerging with COVID-19 cases rebounding and US political risks rising. Emerging markets that rallied earlier this year have fallen back. This includes Latin America, where the pandemic’s per capita death toll is comparable only to Europe and the United States (Chart 1). Latin America is a risky region for investors because the past decade was a lost decade, particularly after the commodity bust in 2014. Poor macro fundamentals, deep household grievances, heavy dependency on commodity prices, and preexisting political polarization and social unrest have weighed on the region’s currencies and government bonds. Latin American equities have underperformed emerging markets over the period (Chart 2). Chart 1Pandemic Adds To Latin America’s Many Woes Chart 2Global Reflation Needed For LATAM To Outperform Looking beyond near-term risks, however, global economic recovery and gargantuan monetary and fiscal stimulus hold out the prospect of a sustained recovery in growth and trade, a weakening US dollar, and a boost to commodity prices (Chart 3). This outlook is favorable for Latin American economies and companies. Chart 3Global Stimulus Keeps Up Commodity Prices In this report, we analyze the coronavirus outbreak and its likely political impact in six Latin American markets: Argentina, Brazil, Colombia, Chile, and Mexico. The crisis is exacerbating the region’s longstanding problems and freezing attempts at supply-side reforms. However, a lot of political risk is already priced, particularly in Mexico and Colombia. Bullish Mexico: Trade War And Leftism Already Peaked As it stands, Mexico has over 740,000 confirmed cases and over 77,000 deaths, with new cases increasing daily (Chart 4). Testing occurs at a rate of 15,300 tests per 1 million people, one of the lowest rates of any major country. Hence the true number of cases is likely well higher than the official count. The health care system is overwhelmed. Chart 4Mexico Not Too Bad On Virus Death Toll The crisis has been a rude awakening for President Andrés Manuel López Obrador (AMLO), but we see Mexico as an investment opportunity rather than a risk. Chart 5Mexico: Left-Wing Unlikely To Outdo 2018 Win AMLO and his National Regeneration Movement (MORENA) swept to power in 2018 as champions of the poor fed up with the country’s corrupt political establishment. Two tailwinds fueled MORENA’s rise: First, the failure of Mexico’s ruling elites. The 2008 financial crisis knocked one of the dominant parties out of power, while the brief comeback of the traditional ruling party (the Institutional Revolutionary Party or PRI) faltered amid the slow-burn recovery of the 2010s. Second, AMLO’s victory was an answer to the populist and protectionist turn in the United States under President Trump, who had vowed to build a wall and make Mexico pay for it as well as to renegotiate NAFTA to be more favorable to the United States. Mexicans voted to fight fire with fire. Neo-liberalism and supply-side structural reform seemed discredited in a blaze of Yankee imperialism and AMLO and his movement offered the only viable alternative. AMLO became Mexico’s first left-wing populist president in recent memory, while MORENA won an outright majority in the Senate and, with its coalition partners, a three-fifths majority in the Chamber of Deputies (Chart 5). From this back story it is clear that investors interested in Mexican assets faced two primary structural risks: (1) a left-wing “revolution,” given AMLO’s lack of legislative roadblocks (2) American protectionism. About 29% of Mexico’s GDP consists of exports to the US (Chart 6). Chart 6Mexico Will Benefit From US Mega-Stimulus Investors took these risks seriously, judging by the relative performance of Mexican energy and industrial equities (Chart 7). Trade war threatened exporters while AMLO aimed to revitalize the moribund state-owned energy company at the expense of foreign investors admitted by his predecessor’s structural reforms Chart 7Investors DisappointedAfter AMLO Election Rally However, the left-wing revolution threat was always overstated: Mexico has become the largest fiscal hawk in the region under AMLO. Moreover, monetary policy had remained overly tight before the pandemic. Indeed, AMLO’s track record as mayor of Mexico City in the early 2000s showed his penchant for fiscal frugality. His left-wing policies have been focused on reviving the state-owned oil company PEMEX and increasing signature social programs, which have been funded by slashing other government expenditures, even during the COVID-19 outbreak. Going forward, Mexico’s orthodox economic policy is a major positive relative to emerging markets with out-of-control debt dynamics, often exacerbated by populist leaders, such as Brazil (Chart 8). MORENA will face greater constraints going forward. AMLO’s approval rating has normalized at around 60%, roughly the average for Mexican presidents (Chart 9). MORENA’s support rate has fallen from 45% to below 20%. With midterm elections looming in July 2021, MORENA is unlikely to outperform its 2018 landslide. So while AMLO will win his proposed 2021 presidential “referendum,” he will do so with a smaller share of the vote and a weakened parliament. Reality has set in for Mexico’s new ruling party. Chart 8Mexico’s Low Debts A Boon Chart 9AMLO’s Approval Rating Solid, But Normalizing AMLO and MORENA are likely to be chastened but not to fall from power, which means there is unlikely to be a wholesale reversal in national policy. The crisis has killed AMLO’s honeymoon but not his presidency. He still has 60% approval and his term in office lasts until 2024. The main opposition parties are still floundering (Chart 10). The creation of six new parties since 2018 will help MORENA either by adding to its coalition or taking votes away from the opposition. US fiscal stimulus and shift away from China benefit Mexico over the long run. Second, we now know that the US protectionist threat was also overstated: President Trump’s first term demonstrates that even if the US elects a populist and protectionist president who pledges to take an aggressive approach toward Mexico, the ties that bind the two countries will not be easily broken. One of the few times Senate Republicans openly defied President Trump was their refusal in June 2019 to allow sweeping 5%-25% unilateral tariff rates on Mexican imports. Hence even if Trump wins and the GOP retains the Senate, Mexico has some safeguards here. Trump would also be constrained by House Democrats on the issue of building a border wall and reforming the US immigration system. AMLO visited Trump in Washington to sign the USMCA ahead of the election. The trade deal is part of Trump’s legacy so Trump is more likely to attack other trade surplus countries than Mexico. Former Vice President Joe Biden and the Democratic Party are more likely to win the US election. In that case, US policy toward Mexico will turn more dovish. House Democrats helped negotiate the USMCA deal and voted to pass it. Biden is unlikely to impose large tariffs on Mexico. It is still possible that US-Mexico tensions will reignite later, if immigration swells under Biden, but the latter is not guaranteed. Two additional macro and geopolitical factors also play to Mexico’s favor over the long run: First, the US’s profligate fiscal policy will benefit its neighbor and trading partner. Massive American monetary and fiscal stimulus – about to receive another dollop of around $2-$2.5 trillion in new spending – will total upwards of 20% of US GDP in 2020 (Chart 11). This is especially likely in the event of a Democratic clean sweep. Yet Democrats are likely to retain the House, preventing Republicans from slashing spending too much even if they convince Trump to adopt their fiscal hawkishness in any second term. Chart 10MORENA’s Approval Comes Down To Earth Chart 11Mexican Exports Will Benefit From US Stimulus Chart 12US Leaving China Will Boost Mexico Industrialization Second, the US is leading a global movement to diversify supply chains away from China. This shift is rooted in US grand strategy and began under the Obama administration, and it is highly likely to continue whether Trump or Biden wins. A Biden victory will result in a more multilateral approach that is more beneficial for global trade, but still penalizes China – which is good for Mexico. No country has suffered a greater opportunity cost from China’s industrialization than Mexico (Chart 12). Both Biden and Trump are advertising a policy of on-shoring that will, in effect, benefit US trading partners ex-China. US current account deficits stem from its domestic savings-investment balance and therefore will persist even if China is cut out, driving production elsewhere. Bottom Line: We are optimistic about Mexico. Trade risk from the US is unlikely to rise higher than during 2017-19, while legislative hurdles facing AMLO and MORENA cannot get much lower than they are today. The currency is fairly valued and equities are not too pricey. Gargantuan US stimulus and a shift away from China dependency will boost growth and investment in Mexico. We will look for opportunities to go long the Mexican peso and assets. Volatile Brazil: Fiscal Restraint Is Gone While much of the world is focused on a second wave of Covid-19, Brazil has struggled to hurdle its first. The country has over 4.8 million confirmed cases (23 000 cases per 1 million people), and 143,000 deaths, second only to the United States. Coronavirus testing in Brazil stands at 73,900 tests per 1 million people, i.e. higher than Mexico’s but not enough to paint a complete picture of the virus’ course (Chart 13). The Brazilian government’s response has been chaotic. With a nearly universal health care system, albeit one that is under-funded, Brazil was not as poorly prepared as some countries. However, like his populist counterparts in Mexico and the United States, Bolsonaro chose to prioritize the economy over the virus response. Brazil was one of the few major countries in the world not to impose a national lockdown. The Ministry of Health, consumed with political turmoil, failed to develop a nationwide plan of action.1 Bolsonaro quarreled with governors who imposed state lockdown measures. With conflicting state and federal messages, Brazilians were unsure about the benefits of social isolation, hand washing, and face coverings, leading to a widespread lack of compliance and a major outbreak of the disease. Bolsonaro’s approach has led to some benefits, however, and the government implemented the largest fiscal response in the region at a whopping 16% of GDP. The economy is recovering faster than that of neighboring countries (Chart 14). Bolsonaro’s approval rating has also improved. The polling looks like a short-term “crisis bounce,” but Bolsonaro is now ahead of his likeliest rivals in 2022, including former President Lula Da Silva and former Justice Minister Sergio Moro. The crisis has catapulted Bolsonaro back into the approval range of other Brazilian presidents, at least for the moment (Chart 15). Chart 13Bolsonaro And Trump Prioritize Recession Over Pandemic Chart 14Bolsonaro's Economy Roaring Back All eyes will next turn to the municipal elections slated for November 15, 2020. The first elections since Bolsonaro came to power will be a test of whether the left-wing opposition can recover. One of the key pillars of Bolsonaro’s political capital was the collapse of the Worker’s Party after the economic crisis and Car Wash corruption scandal of the 2010s. The local government election will also reflect public views of the pandemic. Local governments are important when it comes to combating COVID-19. On April 15, Brazil’s Supreme Federal Court gave them the power to set quarantine restrictions and rules with regard to public transit, transport, and highway use. They are in charge of utilizing numerous rounds of aid from the federal government to mitigate the health and economic effects of the virus. Many have rejected Bolsonaro’s cavalier attitude, imposed stricter health measures, and established local teams comprised of medical professionals, public officials, and private donors to monitor the outbreak. If the Worker’s Party fails to recover from the shellacking it suffered in Brazil’s local elections in 2016, then Bolsonaro’s polling bounce would be reinforced and his administration would get a new lease on life. The opposite is also true: a strong recovery will undercut his political capital, especially because it is still possible that Da Silva will be cleared of corruption charges and capable of running for office in 2022. Bolsonaro also faces a test on another pillar of his political capital: the fight against corruption. A criminal investigation of the administration emerged after the resignation of popular justice Minister, Sergio Moro, who accuses the president of wrongdoing. There is an additional pending investigation for his team’s use of “fake news” during the 2018 campaign, which many deem illegal. So far, however, talk of impeachment has not hurt the president. Only about 46% of Brazilians support impeachment (Chart 16), which is not enough to get him removed from office. Any future impeachment push will depend on the following factors: Chart 15Bolsonaro Enjoys Popularity Boost Amid Pandemic Chart 16Nowhere Near Enough Support For Bolso Impeachment First, the president has allied with an alliance of center-right parties, called the Centrao, that controls 40% of seats in the Chamber of Deputies and has played a historic role in the rise and fall of Brazilian presidents (Chart 17). The Centrao can shield Bolsonaro from impeachment just as its opposition ultimately led to former President Dilma Rousseff’s removal in August 2016. By the same token, if these allies turn on him, removal will become the likely outcome. Second, powerful politicians like House Speaker Rodrigo Maia are reluctant to impeach because it would add “more wood in the fire,” i.e. worsen political instability. It would be bad politics for the impeachment directors as well. But this could change. The other two pillars of Bolsonaro’s political capital are law and order and structural economic reform. Bolsonaro has maintained his law-and-order image through cozy relations with the military, as well as through a slight decline in homicides (Chart 18). Chart 17Brazil: Presidential Parties Small, Need Support From ‘Centrists’ Chart 18Bolsonaro's "Law And Order" Message Works So Far Structural reform is the critical factor for investors, but the crisis has slowed the reform agenda, particularly on the fiscal front. The main way for Brazil to reform is to reduce the size of government. The government takes up a large share of national output, comparable to Argentina, and public debt is soaring. The country was already hurtling toward a sovereign debt crisis prior to COVID-19 (Chart 19). Bolsonaro’s signature legislative achievement, pension reform, has done little to arrest this trajectory, as it was watered down to gain passage and then the pandemic wiped out the fiscal gains. Ironically, Bolsonaro’s improved popularity is negative for fiscal consolidation, since it will encourage him to play the populist ahead of the 2022 election. Pension reform was never popular and passing it did nothing to boost Bolsonaro’s approval rating. On the contrary, his approval began to rise when the pandemic struck and he loosened fiscal policy. Going forward he will need to maintain fiscal spending to rebuild the economy. He is already jeopardizing Brazil’s key fiscal rules. As for the election, Brazil always increases government spending in the year before and year of a presidential election, as all parties hope to buy votes (Chart 20). Chart 19Brazil's Fiscal Crisis Accelerates Chart 20Brazil Cranks Up Spending Ahead Of Elections The implication is that any fiscal hawkishness will have to wait until Bolsonaro’s second term. Of course, if Bolsonaro loses the vote, left-wing parties may return to power and fiscal profligacy will be the order of the day. So investors do not have a good prospect for fiscal consolidation anytime soon, barring a successful candidacy by the aforementioned Moro on a reformist and anti-corruption ticket. Fiscal expansion and loose monetary policy are positive for domestic demand initially but negative for the out-of-control debt profile and hence ultimately the currency and government bond prices over the long term. Outside Brazil, geopolitical conditions are reasonably favorable. If Trump wins, Bolsonaro’s right-wing populism will gain some legitimacy and he may be able to negotiate good trade relations with the United States. If Trump loses, Bolsonaro will become politically isolated, but Brazil will benefit economically, as Joe Biden is friendlier to global trade than Trump. Brazil’s trade openness has grown rapidly, one area of reform that will continue. China is also interested in closer relations with Brazil as it faces trade conflict with the US and Australia. If Trump wins, Bolsonaro benefits from further Chinese substitution away from the United States. If Trump loses, Beijing will not return to former dependencies on the United States. Also, while China cannot substitute Brazil for Australia entirely, it is likely to increase imports from Brazil on the margin (Chart 21). Chart 21Brazil Benefits If China Diversifies From US And Oz Chart 22Brazilian Political Risk Down From 2015-16 Peak Ultimately Brazil is a country filled with political risk due to extreme inequality and indebtedness. But as long as the global economy and commodity prices recover, Bolsonaro will be able to ride the wave and short-term political risks will continue to subside from the extremely elevated levels of 2016 (Chart 22).   Bottom Line: Bolsonaro’s popularity bounced in the face of the national crisis. Local elections in November are an important barometer of whether his administration and its neoliberal structural reform agenda can survive beyond 2022. Either way, fiscal consolidation is on hold prior to the 2022 election. We are long Brazilian equities as a China play, but the outlook is ultimately negative for the currency. Bearish Argentina: Peronism Restored Argentina has 751,000 cases of coronavirus (16,800 cases per 1 million people) and about 16,900 deaths. Testing stands at 41,700 test per 1 million people. After the federal government eased quarantine restrictions and began reopening most of the country on June 7, total cases followed the general trend of the region (Chart 23). Chart 23Argentina’s COVID-19 Suppression Losing Steam Despite early measures to flatten the curve, Argentina lacks hospital beds, doctors, and medical supplies, especially in the capital of Buenos Aires where 88% of the country’s confirmed cases are found. The coronavirus has exposed stark differences between the rich and poor in terms of access and quality of health care, with about a third of the population uninsured. Politically secure, Fernandez has prioritized the medical crisis over the economy, imposing some of the world’s strictest lockdown measures in mid-March and declaring a one-year national health emergency – the first country in Latin America to do so. However, Argentina’s multi-decade economic mismanagement and recent policy vacillations mean that the crisis came at a bad time. Argentina has been in a deep recession for over two years, with skyrocketing inflation and peso devaluation, excessive budget deficits and external debts, and a 10% poverty rate in 2018 (Chart 24). Former President Mauricio Macri’s badly needed but ultimately failed attempt at supply-side reforms resulted in an economic collapse that saw the left-wing Peronist/Kirchnerista faction regain power in 2019. Argentina’s fiscal problems will continue on the back of populist economic unorthodoxy. Sovereign risk has temporarily fallen. Argentina received a $300 million emergency loan from the World Bank and another $4 billion loan from the Inter-American Development Bank. The country has defaulted on sovereign debt nine times, but the Fernandez government reached a deal with its largest creditors to restructure $65 billion in early August. The government agreed to bring some debt payments forward, thus buying itself immediate debt relief. It now has a little more than five years until the debt pile’s biggest wave of maturities comes due (Chart 25). Chart 24Poverty Rates Spike Amid Crisis, Including In Argentina Chart 25Argentina's Sovereign Risk Will Rise From Here This deal will give President Fernandez a significant boost. He took office in December 2019 so he has time to ride out the crisis before facing voters again in 2023. However, his reliance on populist economic unorthodoxy ensures that Argentina’s fiscal problems will continue. Consider the following: Before Covid-19, in an attempt to regain credibility among international lenders, Fernandez appointed Martin Guzman, as Minister of Economy. Guzman is an academic and a disciple of American Nobel-prize winner Joseph Stiglitz, but has little policy-making experience. Fernandez pushed an Economic Emergency Law through Congress, giving him emergency powers to renegotiate debt terms and intervene in the economy. He re-imposed import-substitution policies, such as large tax increases on agricultural exports, currency controls, and utility price freezes. In Fernandez’s inauguration speech, he justified a return to leftist policies by saying, “until we eliminate hunger we will ask for greater solidarity from those who have more capacity to give it.” This is a traditional trap for Argentina which results in worse economic outcomes over the long run. Chart 26Argentina’s Government Scores Well In Opinion Fernandez’s government has increased fiscal spending on food aid and other safety nets for the unemployed and furloughed. It has required banks to give out loans at reduced interest rates. Initially it pledged 2% of GDP to social and welfare relief programs, but that number has risen since the onset of the pandemic. For now, Fernandez has considerable political capital. The crisis will wipe out the memory of the Kirchneristas’ previous failings. Social spending is now flowing to Fernandez’s political base and the informal sector of the economy, which accounts for almost half of all Argentine workers. Public support for Fernandez has remained strong through the economic woes and pandemic, with his approval rating at around 67%. Over 80% of people polled have confidence in the government’s handling of the virus (Chart 26), according to opinion polls. Profligate spending will likely continue beyond the cyclical demands of the current crisis, adding to Argentina’s unsustainable debt profile. When the pandemic subsides, international lenders will be less willing to extend credit to Argentina and invest, given their record of default and high tax rates. International companies and even small caps have fled the country due to its draconian currency controls. Bottom Line: Argentina has witnessed a fall in uncertainty but going forward political risk will revive. Populist Kirchnerista policies do not create productivity improvements or reduce debt, and the country’s macro fundamentals will underperform in the long run. RIP Venezuela: The Final (Final) Nail In The Coffin For years, Venezuela has suffered an economic crisis with high levels of unemployment, hyperinflation, and mass shortages of food, medical supplies, and even gasoline. Many citizens claim they’re more likely to die from starvation than the coronavirus. Out of the country’s 47 hospitals that are supposedly dedicated to COVID-19, only 57% have a regular water supply, while 43% have a shortage of PPE kits for medical staff and practitioners. Nicolas Maduro – the hapless successor to Hugo Chavez – declared a state of emergency and implemented a nationwide and long-lasting lockdown, enforced by police. The government issued a unique “7 + 7” plan, where strict lockdowns are imposed for seven days, relaxed for another seven days, re-imposed, and so on. Nevertheless, cases have been increasing. Over time the crisis in Venezuela has forced around five million Venezuelans, including skilled workers and medical doctors, to leave the country (Chart 27). Spillover effects are straining neighboring Colombia, which has taken in 1.5 million of the refugees, and Brazil. Although thousands of Venezuelans have returned home during the pandemic, the massive movements will only make the virus more prevalent. In early June, Maduro reopened borders with Colombia after closing them in February when opposition leader (and rival claimant to the presidency) Juan Guaidó tried to import foreign aid. Maduro denied that Venezuela is in humanitarian crisis and warned against a coup d'état by the United States. The political opposition is stymied for now. In January 2019, Guaidó declared himself president of Venezuela over Maduro, whose government has circumvented the constitutional system since losing the parliamentary election of 2015. Guaido receives broad support from the international community, including Europe and the United States, while Maduro is backed by China, Russia, and Iran. Over 18 months later, Guaidó wields nearly no power at home and Maduro remains in place with the army’s top generals still backing him. However, the Trump administration has expanded sanctions throughout its term. Maduro is unable to access international financing from the IMF, after requesting an emergency $5 billion loan to combat COVID-19, partly due to US opposition. Food prices in Venezuela have risen 259% since January. Low worldwide demand for oil – representing 32% of Venezuelan GDP – means the last leg of the economy has weakened. The government has little room to maneuver fiscally or otherwise combat the virus. Maduro has used the crisis to strengthen his domestic security grip. The military, police, and revolutionary militias are enforcing lockdowns to thwart demonstrations. The opposition is divided, with Guaidó now quarreling with former opposition leader Henrique Capriles over whether to contend the parliamentary elections on December 6. The elections will inevitably be rigged; but to boycott them is to allow Maduro officially to retake the key constitutional body that he lost (and then sidelined) back in 2016. Nevertheless, the material foundations of the country have long collapsed (Chart 28). The pandemic and recession will ultimately prove the final (final, final) nail in the coffin. The military is ruling from behind the scenes but will not want to jeopardize its own status when the Bolivarian revolution is finally abandoned. The timing of this denouement is, as always, anybody’s guess. Chart 27Venezuela’s Refugees Show State Collapse Chart 28Venezuela's Regime Cannot Survive   Bottom Line: President Trump will maintain maximum on Maduro and Venezuela as long as he is in office. The regime will struggle to survive long enough to enjoy the benefits of the commodity price upswing next year. Whenever Maduro falls, the prospect of an eventual resuscitation of oil production will open up. Bullish Colombia: Political Risk Contained (For Now) Chart 29Colombia Flattened The Curve The Colombian government responded swiftly to COVID-19. President Ivan Duque shut seven border crossings with Venezuela, declared a state of emergency, and imposed lockdown measures in mid-March. The measures have been stringent and extended. The effect on the spread of the disease is discernible compared to Colombia’s neighbors (Chart 29). The city of Medellin, with 2.5 million residents and only 2,399 coronavirus deaths, became the best-case scenario for combating the virus. Through the use of an online app, the city government connected people with money and food, while obtaining important data to track cases. Despite the lockdowns, fiscal policy has been tight. True, the government provided payroll subsidies for formal and informal workers unable to work during lockdowns.2 But government spending as a whole is limited (Chart 30). This is positive for the country’s currency and government bonds but will exacerbate political tensions later. Chart 30Colombia's Fiscal Hawkishness Good For Currency, But Will Spur Opposition Duque’s approval ratings were low back in February (23%) but nearly doubled when the crisis struck (Chart 31). However, they have since fallen back to around 40% and high unemployment and fiscal restraint will challenge his government in coming years. Chart 31Colombia’s President Struggling, But Has Time To Recover Pre-Election Colombia is relatively politically stable but tensions are building beneath the surface that will challenge the country’s recent improvements in governance and the 2016 peace deal. On August 4, former President Alvaro Uribe was put under house arrest by a section of the Colombian Supreme Court amid an investigation on witness tampering. He was the first ex-president to be detained in Colombia’s history. Subsequently he resigned from the Senate to obtain better treatment at the hands of the more friendly Attorney General’s office. Uribe is powerful. He created Centro Democratico, which is the largest party in the Senate and the second largest in Congress. He also hand-picked President Duque. His case will continue to be a source of political polarization. Right-leaning factions have not yet convinced moderates to oppose the country’s UN-backed 2016 peace deal, which ended decades of fighting between government forces and the Revolutionary Armed Forces of Colombia (FARC), the leading rebel group. If that changes, then domestic security will decline and investor sentiment will decline at least marginally. Colombia’s political polarization will be contained by Venezuela’s collapse – as long as the economy recovers. In the wake of the oil bust in 2014, Colombia saw the left-wing factions unite around a single candidate – Gustavo Petro, an ex-guerilla – who challenged the conservative establishment in the 2018 election, pledging to tackle inequality. Petro was soundly defeated, giving markets reason to cheer. Now, however, inequality is combining with a deep recession, austerity, and the potential for a failed peace process to challenge the conservatives in 2022. Table 1Latin America Is Vulnerable To Social Unrest Chart 32MXN, COL, And CLP Outperform While BRL Lags The saving grace for the conservatives will likely be the global cyclical upswing, combined with Venezuela’s collapse continuing to unite the right and divide the left. However, the Uribe faction’s dominance is getting long in the tooth and Colombia is vulnerable to social unrest based on our COVID-19 Unrest Index (Table 1). The election is not all that soon. The Colombian peso is still relatively cheap and yet has outperformed other emerging market currencies due to the strong COVID-19 response and the oil rally (Chart 32). Bottom Line: Tight fiscal policy combined with a strong pandemic response – and the recovery in oil prices – will benefit the Colombian peso. Equities are attractively valued. Political risk will build as the 2022 election draws closer, however. Volatile Chile: Tactical Buys Hinge On Politics, China Chile has been a hotspot for the coronavirus. Its lackluster response to the pandemic is fanning the embers of the social unrest that erupted last year. Unrest is tied to a larger political crisis unfolding over the constitutional order, which evolved from the 1980 constitution of dictator Augusto Pinochet. Chile is transitioning from a neoliberal economic model to a welfare state, as Arthur Budaghyan and Juan Egaña of BCA’s Emerging Markets Strategy showed in an excellent special report last year. This transition raises headwinds for an currency, equities, and government bonds. The Chilean government, led by President Sebastián Piñera, declared a state of emergency in March and boosted health care spending throughout the country. The government also passed numerous emergency relief packages to small businesses, workers of the informal economy, and local governments. However, high levels of poverty and overcrowding, especially in the capital of Santiago, have hindered efforts to contain the coronavirus (Chart 33). The government imposed strict lockdowns, including a nationwide increase in police and up to five-year prison penalties for violating quarantines. The political opposition argues that Piñera’s extension of the “state of catastrophe” has allowed him to use emergency powers to restrict citizens’ rights in the name of curbing the pandemic. His approval rating has fallen beneath 22% while popular disapproval has surged above 68% (Chart 34). Chart 33Chile’s Handling Of COVID-19 Largely Successful Chart 34Chile’s Govt Embattled Amid Constitutional Rewrite Chart 35Chile: Inequality Falling, But High Level Still Sparks Unrest Chile was already a tinderbox before the pandemic. Beginning with a small hike to subway fares in Santiago in October 2019, pent-up social grievances erupted against the country’s elite. Protests have continued even during lockdowns and morphed into demands for broader social reform (Chart 35). Chile's top rank on our COVID-19 Social Unrest Index belies the fact that it has high wealth inequality, a threadbare social safety net, high debt levels, and now higher unemployment (Table 1). Table 1Latin America Is Vulnerable To Social Unrest In a concession to protesters, the Piñera administration agreed to revise the constitution. A popular referendum will be held on October 25, though it has already been delayed once. The referendum will determine whether to hold a direct constitutional assembly, whose members are drawn from the population as a whole, or a mixed constitutional assembly, in which congress takes up half of the seats. The latter is the more conservative option; the former is more progressive and will deepen political polarization as the political establishment will resist it (Chart 36). The process to revise the constitution is supposed to last until the end of 2022 but it could drag on longer. Moreover it will be complicated by presidential and legislative elections slated for November 2021. The timing of these events ensures that short-term partisan factors will have a major impact on constitutional revision, which bodes ill for resolving structural political problems. The Piñera administration’s goal is to pacify the protesters with some reforms, thus winning his party re-election, while preserving key elements of the current political establishment. But the pandemic has made it harder to do this, requiring either greater government concessions or a new round of unrest. The implication is that political risk will remain elevated over the next few years. Political risk will thus undermine good news on the macro front, including the peso’s strong performance this year so far (Chart 32 above). Of course, there are positive macro factors countervailing this political risk. One of which is China’s recovery. Beijing accounts for 51% of global copper demand, and Chile provides 28% of mine supply, and China is stimulating aggressively. Chilean exports track even more closely with China’s credit impulse than those of other Latin American economies (Chart 37). Chart 36COVID-19 Unrest Index: If Chile Faces Unrest, Then All Latin America Faces Unrest However, the market has partly priced China’s boost whereas Chile’s political risk will erupt again soon. With regard to the US election, Chile stands to benefit from a Democratic victory that improves the outlook for China’s economy and global trade. Like Peru, Chile is a member of the CPTPP and stands to benefit if Biden is elected and eventually rejoins this pact. Chart 37Chile Constitutional Battle Will Increase Political Risk   Bottom Line: A secular rise in domestic political risk as the country is pressured to expand the social safety net is a negative factor for the peso and stock market that will weigh on its otherwise positive macro backdrop. Investment Takeaways The above review reveals some common threads. First, the last decade has not led to lasting neoliberal reforms or major strides in promoting productivity. Attempts at supply-side structural reform have been modest or have failed entirely in Argentina, Brazil, Chile, and Mexico. Colombia’s attempt at a peace deal may falter. Venezuela is a failed state. Second, populism, whether left-wing or right-wing, entails that most governments will pursue economic growth at any cost. Fiscal hawkishness has been put on pause, with the exception of Mexico and Colombia, where it will benefit the currencies. Near-term risks abound in Q4 2020 but the long term is favorable for Latin American financial assets due to global reflation. China is stimulating its economy aggressively. US sanctions will weigh on China, but it will need to stimulate more in response to maintain internal stability. This will boost commodity prices. The dollar will eventually weaken as global growth recovers, the Fed avoids raising rates, and the US maintains large twin deficits. This is ultimately true even if Trump is re-elected. A weaker dollar helps commodities and Latin American countries with US dollar debts. All things considered, Mexico and Colombia will come out looking the best, but we will also look for opportunities when discounts on Chilean assets become excessive. The US’s secular confrontation with China over trade tensions holds out the prospect of Latin American markets reversing their long equity underperformance relative to Asian manufacturers (Chart 38). Latin American manufacturers like Mexico will benefit from American trade diversification. If the US joins the CPTPP, then Chile and Peru will also benefit. Metals producers like Chile will benefit most from China’s stimulus. Chart 38China's Stimulus A Boon For Latin America   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Daniel Kohen Consulting Editor Footnotes 1 The Ministry of Health exemplifies growing fractures across the administration. In mid-May, the Health Minister (Nelson Teich) resigned just four weeks into the job, after Bolsonaro fired the previous one (Luiz Henrique Mandetta) for defending lockdown measures imposed by some mayors and governors. 2 There are about 1.8 million Venezuelan refugees in Colombia. They rely on the informal work, with many falling back into poverty as a result of the mandatory quarantines.

Feature Analysis on Korea & South Africa are available on pages 6 and 10, respectively. Mexico: Balancing Pros And Cons We have been overweight Mexican sovereign credit and local currency bonds as well as equities relative to the respective EM benchmarks. Our rationale for this stance has been the fact that Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. However, the COVID-19 outbreak has introduced new dimensions into this analysis. On one hand, there are a number of positives that still warrant a lower macro risk premium on Mexican assets: The nation’s public debt burden is rising sharply but is not yet at an unsustainable level. We estimate that assuming (1) a nominal GDP contraction of 7% in 2020, (2) an overall fiscal deficit of 4.7% of GDP this year, and (3) the peso’s exchange rate versus the US dollar at 26, the gross public debt-to-GDP ratio will rise to 49% from 37% currently (Table I-1). If we assume the government takes over all SOE debt, including that of Pemex, total gross public debt will rise to 62% of GDP (Table I-1). While non-trivial, Mexico’s public debt burden is considerably lower than those in large EM countries like Brazil and South Africa. Table I-1Mexico's Public Debt Burden Chart I-1Mexico: Real And Nominal Rates Are Too High Despite widespread investor concerns, President AMLO has been running a very tight fiscal policy. At the end of 2019, the government had a primary surplus of 1% of GDP, and the overall deficit stood at 1.6%. In fact, given AMLO’s ideological approach to fiscal frugality, his government’s fiscal response to the COVID-19 pandemic to date has actually been less than what it can or should be. Similarly, monetary policy has been very tight. This is positive for creditors but negative for growth. The central bank has erred on the hawkish side and has a lot of room to reduce interest rates. Nominal and real interest rates in Mexico are among the highest in the EM universe (Chart I-1). Very tight fiscal policy means that monetary policy can be relaxed considerably. Interest rates in Mexico have a lot of downside.   Finally, the peso is reasonably cheap, according to the real effective exchange rate based on CPI and PPI measures (Chart I-2). Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. On the other hand, there are considerable negatives, especially regarding the growth outlook: A year and a half into his mandate, president AMLO has not been able to secure the corporate sector’s confidence in his administration’s policies. The government was attempting to reverse this trend in the months leading up to the COVID-19 outbreak by announcing a public-private infrastructure package and improving relations with the US. Nevertheless, the decision to shun large corporations from the national fiscal response has once again weighed on business confidence. This will further reduce capital spending and hiring, prolonging the recession (Chart I-3). Chart I-2The Mexican Peso Is Cheap Chart I-3Business Confidence Plummets Again   The government’s fiscal response to the COVID-19 pandemic has been insufficient. The central government announced measures to increase funding for social and infrastructure programs and loans for households as well as small and medium businesses, amounting to a mere 3% of GDP. This is one of the lowest stimulus packages among major economies worldwide (Chart I-4). Chart I-4Mexico's Fiscal Response Is Poor Mexico is highly levered to the US economy. A deep contraction in American demand for consumer discretionary goods and international travel will suffocate Mexico’s export revenues. Exports of automobiles and tourism revenues together account for 37% of total goods and services exports, and 13% of GDP (Chart I-5). Balancing pros and cons, we recommend the following strategy for Mexican markets: Continue to overweight local currency bonds and sovereign credit within their respective EM benchmarks (Chart I-6). Orthodox fiscal and monetary policies warrant an overweight stance on fixed-income plays. Chart I-5Autos And Tourism Revenues Are Significant Chart I-6Mexico Versus EM: Domestic Bonds And Sovereign Credit   We reiterate our trade to receive Mexican 10-year swap rates. The only reason we are reluctant to be long cash domestic bonds is the potential for further currency depreciation. Finally, we are maintaining an overweight stance on equities, even though we acknowledge the very bad profit outlook. However, historically whenever Mexican interest rates have fallen relative to EM, Mexican stocks have typically outperformed the EM equity benchmark (Chart I-7). This is the primary rationale behind our equity overweight stance. Chart I-7Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices   Juan Egaña Research Associate juane@bcaresearch.com   South Korea: Bonds Offer Value Amid Looming Deflation The South Korean economy is facing strong deflationary pressures, requiring significant and additional rate cuts. Meanwhile, 10-year government bonds yield are still at 1.4%, 75 basis points over 10-year US Treasurys (Chart II-1). Hence, Korea’s bond yields offer good value for fixed-income investors and have considerable downside. We have been receiving 10-year swap rates in Korea since 2011 and are reiterating this recommendation: Chart II-2 shows that the GDP deflator has been negative since 2018, and core and trimmed mean consumer prices are flirting with deflation. Chart II-1Korean Government Bonds Yields: More Room To Fall Chart II-2The Korean Economy Is Flirting With Deflation   Falling prices amid elevated corporate and household debt levels – at 102% and 96% of GDP respectively – is toxic. The basis is price deflation increases real debt burdens. Notably, the debt service ratio for businesses and households is very high at 19.9% of GDP. There is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Exports – which account for some 40% of GDP – are plunging. The business survey from Bank of Korea suggests exporters’ business sentiment plunged by a record in May and is close to 2008 levels, pointing to a dreadful export outlook. (Chart II-3) Domestic demand will remain weak, despite the large fiscal response to the COVID-19 outbreak. Business investment and hiring will be depressed for a while, undercutting consumer spending (Chart II-4). Chart II-3Exports In Freefall Chart II-4Less Investment Plan And Poor Employment Outlook Chart II-5Falling Residential Construction Permits Finally, residential investment was in the doldrums even before the COVID-19 outbreak. Chart II-5 illustrates that declining residential construction permits preclude lower residential construction for the rest of the year. The Bank of Korea will have to cut interest rates considerably this year. From a big-picture perspective, there is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Korea’s economy shares many similarities with advanced economies like high debt levels and persistent deflationary pressures. On top of this, Korea is much more exposed to global trade, which makes its cyclical outlook worse, heralding substantial monetary easing. Exchange Rate Low interest rates could undermine the Korean won, even though the exchange rate has not historically been driven by interest rate differentials. The key driver of the won – shrinking global trade volumes and deflating tradable goods prices – warrants a cheaper currency to mitigate the negative impact on corporate profitability (Chart II-6). Chart II-6Deflating Export Prices Herald Currency Depreciation Chart II-7Deflating Semiconductor Prices...   Besides, deflation in DRAM prices (Chart II-7) as well as DRAM sales point to further currency depreciation and lower Korean tech stock prices (Chart II-8). Chart II-8...Does Not Bode Well For Tech Stocks Overall, a weak currency is needed to alleviate deflationary pressures currently present in the economy. Stocks We are negative on the KOSPI in absolute terms but continue to recommend that EM-dedicated equity portfolio investors overweight this bourse. Despite being a highly cyclical market, we believe the KOSPI’s outperformance will be due to its large weight in tech stocks. The latter will benefit from China’s ambitious tech-related infrastructure plan in the coming years. The plan includes construction of Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet and data centers. We expect total investment will reach between US$182 billion and $266 billion by the end of 2020, an increase of 30-50% over last year. Importantly, 40% of Korea’s semiconductor exports are purchased by China. We have been playing the semiconductor theme via Korea rather than Taiwan because the latter is a wild card amid escalating geopolitical tensions between the US and China. Our geopolitical team expects a flare up in US-China tensions ahead of US elections this year, and Taiwan could become one of the focal points. Bottom Line: Continue receiving 10-year swap rates, shorting the won against the US dollar and overweighting the KOSPI within an EM dedicated equity portfolio. Lin Xiang, CFA Research Analyst linx@bcaresearch.com South Africa: A Point Of No Return On Public Debt South Africa’s public debt is bound to surge to unsustainable levels: from 62% of GDP in 2019 to 95% of GDP by the end of 2021. If the government is forced to take over unsustainable debt from state-owned enterprises, which is very likely, it will push up the public debt-to-GDP ratio further by another nine percentage points to 104% of GDP. Table III-1 summarizes South Africa’s public debt projections using the following parameters and assumptions: To fight the COVID-19-induced economic crunch, President Cyril Ramaphosa recently announced a fiscal stimulus package of $26 billion (R500 billion), or 10% of GDP. Using recent government and central bank projections for 2020 and 2021, nominal GDP growth is expected to contract by 2.5% and expand 6.7%, respectively. Notably, fiscal revenue growth is expected to fall by 32% in nominal terms, according to recent comments by the Minister of Finance.1  Meanwhile, government spending will grow by 15%,2 and the primary fiscal deficit is expected to widen to 15.4% of GDP in 2020. Given that government forecasts often tend to be optimistic, chances are that both the primary deficit and public debt-to-GDP ratio will overshoot these forecasts. Finally, the sharp drop in domestic demand will increase the odds of a default among state-owned enterprises, with Eskom likely being a case in point. Current government guidelines require at least two thirds of Eskom’s R450 billion debt to be transferred to government balances in the event of default or anticipated default. In such a case, this increases the government debt-to-GDP ratio by an additional R350 billion, or 7% of GDP. Table III-1Projections For South Africa Fiscal Position And Public Debt Altogether, the public debt-to-GDP ratio will surge to 104% of GDP by the end of 2021 (Chart III-1). With public debt above 100% of GDP, interest rates well above nominal GDP and the government running large primary deficits, debt dynamics will become unsustainable. To avoid a public debt crisis, the government should either run large primary surpluses, which is unfeasible anytime soon, or bring down government borrowing costs to push up nominal GDP above interest rates (Chart III-2). Chart III-1Public Debt-To-GDP Will Balloon To 104%! Chart III-2Unsustainable Gap Between Local Yields And Nominal Growth   The latter option is the only one that is politically feasible. But to do so, the central bank needs to resort to the monetization of public debt. The central bank (SARB) has already taken the first step to bring down bond yields by buying government bonds in the secondary market. While the rationale of that was to cover foreign investors’ selling of local currency bonds, it amounts to nothing else but quantitative easing, or public debt monetization. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. As such, debt monetization is a fait accompli in South Africa. Monetizing part of the government’s debt will help reduce real borrowing costs and at the same time reflate nominal GDP growth, thereby boosting government revenues. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. If foreigners continue to sell the local currency bond market, the SARB and commercial banks will need to buy more government debt, creating even more money. This is why we expect the rand to continue depreciating. Investment Recommendations Chart III-3The Rand Could Drop Further Given Public Debt Dynamics The currency will likely get cheaper provided the rising odds of outright public debt monetization (Chart III-3). Continue shorting the rand versus the US dollar. We are initiating a new position of receiving 2-year swap rates. Odds are that the central bank will cut rates further in the months to come. Remain underweight local currency bonds in an EM-dedicated portfolio. Even though local domestic rates will likely fall, South African bonds will not outperform the EM benchmark on a total return in US dollar basis, mostly due to chronic currency depreciation. Finally, investors should underweight sovereign credit (government US dollar bonds) due to the unsustainable public debt dynamics. Dedicated EM equity portfolio investors should maintain a below-benchmark allocation to this bourse. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     The Minister of Finance made remarks about tax revenue falling by 32% in nominal terms. Tax revenues represent almost 100% of overall revenue. 2     Overall fiscal package is estimated to be 3% of GDP. This excludes reprioritization in 2020 around R130 billion & loan guarantee scheme of R200 billion. Overall total additional spending amounts to R170 billion in 2020 fiscal year. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

We have been overweight Mexican sovereign credit and local currency bonds as well as equities relative to the respective EM benchmarks. Our rationale for this stance has been the fact that Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. However, the COVID-19 outbreak has introduced new dimensions into this analysis. On one hand, there are a number of positives that still warrant a lower macro risk premium on Mexican assets: The nation’s public debt burden is rising sharply but is not yet at an unsustainable level. We estimate that assuming (1) a nominal GDP contraction of 7% in 2020, (2) an overall fiscal deficit of 4.7% of GDP this year, and (3) the peso’s exchange rate versus the US dollar at 26, the gross public debt-to-GDP ratio will rise to 49% from 37% currently (Table I-1). If we assume the government takes over all SOE debt, including that of Pemex, total gross public debt will rise to 62% of GDP (Table I-1). While non-trivial, Mexico’s public debt burden is considerably lower than those in large EM countries like Brazil and South Africa. Table I-1Mexico's Public Debt Burden Despite widespread investor concerns, President AMLO has been running a very tight fiscal policy. At the end of 2019, the government had a primary surplus of 1% of GDP, and the overall deficit stood at 1.6%. In fact, given AMLO’s ideological approach to fiscal frugality, his government’s fiscal response to the COVID-19 pandemic to date has actually been less than what it can or should be. Similarly, monetary policy has been very tight. This is positive for creditors but negative for growth. The central bank has erred on the hawkish side and has a lot of room to reduce interest rates. Nominal and real interest rates in Mexico are among the highest in the EM universe (Chart I-1). Very tight fiscal policy means that monetary policy can be relaxed considerably. Interest rates in Mexico have a lot of downside.   Finally, the peso is reasonably cheap, according to the real effective exchange rate based on CPI and PPI measures (Chart I-2). Chart I-1Mexico: Real And Nominal Rates Are Too High Chart I-2The Mexican Peso Is Cheap   Chart I-3Business Confidence Plummets Again On the other hand, there are considerable negatives, especially regarding the growth outlook: A year and a half into his mandate, president AMLO has not been able to secure the corporate sector’s confidence in his administration’s policies. The government was attempting to reverse this trend in the months leading up to the COVID-19 outbreak by announcing a public-private infrastructure package and improving relations with the US. Nevertheless, the decision to shun large corporations from the national fiscal response has once again weighed on business confidence. This will further reduce capital spending and hiring, prolonging the recession (Chart I-3). The government’s fiscal response to the COVID-19 pandemic has been insufficient. The central government announced measures to increase funding for social and infrastructure programs and loans for households as well as small and medium businesses, amounting to a mere 3% of GDP. This is one of the lowest stimulus packages among major economies worldwide (Chart I-4). Chart I-4Mexico's Fiscal Response Is Poor Chart I-5Autos And Tourism Revenues Are Significant Mexico is highly levered to the US economy. A deep contraction in American demand for consumer discretionary goods and international travel will suffocate Mexico’s export revenues. Exports of automobiles and tourism revenues together account for 37% of total goods and services exports, and 13% of GDP (Chart I-5). Balancing pros and cons, we recommend the following strategy for Mexican markets: Continue to overweight local currency bonds and sovereign credit within their respective EM benchmarks (Chart I-6). Orthodox fiscal and monetary policies warrant an overweight stance on fixed-income plays. We reiterate our trade to receive Mexican 10-year swap rates. The only reason we are reluctant to be long cash domestic bonds is the potential for further currency depreciation. Finally, we are maintaining an overweight stance on equities, even though we acknowledge the very bad profit outlook. However, historically whenever Mexican interest rates have fallen relative to EM, Mexican stocks have typically outperformed the EM equity benchmark (Chart I-7). This is the primary rationale behind our equity overweight stance. Chart I-6Mexico Versus EM: Domestic Bonds And Sovereign Credit Chart I-7Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices   Juan Egaña Research Associate juane@bcaresearch.com  

Highlights Bear markets occur in phases, and their narrative can mutate. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. We are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar as well as our defensive positioning in EM domestic bonds and credit markets. We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. We are also booking gains on our long Russian domestic bonds/short oil position. Feature Chart I-1A Record Low Currency VOL Is Followed By Major Market Disturbances Global financial markets are witnessing the unwinding of the policy put. For the past several years, the consensus in the global investment community was that risk assets could not go down because of policy puts from the Federal Reserve, the US Treasury and President Trump, the European Central Bank and the Chinese authorities. Similarly, crude oil prices had been supported by OPEC 2.0’s put from December 2016 until recently. The latest panic and broad-based liquidation of risk assets has been due not only to fear and uncertainty related to the rapid escalation in COVID-19 cases around the world, but also to investor realization that these policy puts are ineffectual. The Fed’s 50-basis-point intra-meeting rate cut proved incapable of stabilizing global risk assets. Investors have begun to doubt the efficacy of policy puts and have thrown in the proverbial towel. Crucially, the high-speed and intensity of the selloff was due to widespread complacency and overbought conditions in risk assets. In our January 23 report, we quoted Bob Prince, co-CIO of Bridgewater, who stated in Davos that “…we have probably seen the end of the boom-bust cycle.” This comment was consistent with prevalent complacency in global financial markets, reflected in very tight credit spreads worldwide, high US equity multiples and record-low implied volatility in various asset classes. In the same January 23 report, we wrote: “Any time an influential person has made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets.” In that same report , we recommended going long implied EM currency volatility. Since then JP Morgan’s EM currency volatility has risen from 6% to 10%. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. Consistent with this thesis, we reinstated our short EM equity index recommendation in the following week’s report – on January 30. The MSCI EM stock index is down 11% since then. Our target is 800, which is 18% below current levels (Chart I-2, top panel). Chart I-2EM Stocks: A Breakdown In The Making Market Narratives Mutate Chart I-3VIX Surge In Early 2018 Was A Trigger Not Cause Of Selloff Narratives of all large market moves are always expounded in retrospect. Only after a selloff is well-advanced do investors and commentators come up with reasons for it and build a plausible narrative describing it. Critically, bear markets occur in phases, and their narrative can evolve. What began as a selloff caused by the coronavirus outbreak could well mutate into an oil crash-led selloff, and then mutate again into a selloff due to policy omnipotence, or something else. For example, the early 2018 selloff in global equities and industrial commodities was at the time attributed to the spike in US equity volatility (Chart I-3, top and middle panels). In retrospect, January 2018 marked a major top in the global business cycle (Chart I-3, bottom line). Hence, the true reason for the late-January 2018 top in global stocks and industrial commodities was a downturn in global manufacturing and trade and not the surge in the VIX. The key question investors are currently wrestling with is the following: How deep will this selloff be, and how long will it last? Our view is that the selloff in EM and global risk assets is not yet over. As such, we are reiterating our short positions in the EM equity index and a basket of EM currencies versus the US dollar, as well as our defensive positioning in EM domestic bonds and credit markets. Gauging The Downside There is no doubt that global growth will be affected by the spread of COVID-19 and the precautionary measures taken by the authorities, companies and households around the world to contain the outbreak.   Further, growth visibility is extremely low, and that uncertainty is raising the risk premiums that investors demand. The latter is weighing on risk assets in general and global share prices in particular.  Presently, precise forecasts for GDP growth and a potential trajectory of COVID-19 cases are not credible, and hence cannot be relied upon to formulate a sound investment strategy. If the current bloodbath in risk assets persists, a market bottom could be reached well before bad economic data are released or COVID-19 infection cases peak. Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. With respect to valuations and technicals, we have the following observations: The EM equity index seems to breaking below its major support lines. If this breakdowns transpires, there is an air pocket until the index reaches its next technical support, which is 18% below its current level (please refer to the top panel of Chart I-2 on page 3). If the EM MSCI equity index drops to this support range, it would be trading at 11 times its trailing earnings (please refer to the bottom panel of Chart I-2 on page 3). At those levels, the EM equity index would be discounting a lot of bad news, making it immune to dismal economic data and general uncertainty. For the S&P 500, if the current defense line – which held been during 2011, 2015 and 2018 selloffs – is violated, the next long-term technical support is around 2400-2500 (Chart I-4). Inflows to EM fixed-income funds were enormous in 2019. Meanwhile, EM corporate and sovereign spreads have broken out (Chart I-5). Provided this selloff commenced from very overbought and expensive levels, the odds are that liquidation forces will not abate right now and that the selloff in EM fixed income has further to go. Chart I-4S&P 500: Where Technical Support Lies? Chart I-5EM Sovereign And Corporate Spreads Have Broken Out   In a nutshell, we suspect that EM local currency bonds and credit markets received a lot of inflows from European investors in recent years because yields were negative across European fixed-income markets. A weak euro was a boon for European investors investing in EM. That, however, is reversing. Since the recent sharp appreciation in the euro and the nosedive in EM currencies, EM financial market returns in euros have collapsed. This will likely prompt an exodus of European investors from EM financial markets. Chart I-6A Major Breakdown In This Cyclical Indicator Even though the EM equity index is not expensive or overbought, rising EM USD and local currency bond yields herald lower share prices, as we discussed at length in last week’s report. Our Risk-On/Safe-Haven currency ratio1  has plummeted below its major technical support and the next level is significantly lower. In other words, this indicator is also in an air pocket (Chart I-6). Given it is extremely well-correlated with EM share prices, the latter will not bottom until this indicator stabilizes. Technical configurations of high-beta and cyclical segments of the global equity universe are consistent with failed breakouts. Such a profile is typically not followed by a correction, but by a major drawdown. These include the European aggregate equity index, the Nikkei, global industrials and US high-beta stocks (Chart I-7). Chart I-7AFailed Breakouts Are Often Followed By Large Drawdowns Chart I-7BFailed Breakouts Are Often Followed By Large Drawdowns Chart I-8The Global Stocks-To-Bonds Ratio Is Back To 2011 Levels Finally, the global stock-to-bond ratio has decisively broken below the upward sloping channel that has been in place since 2009 (Chart I-8). Typically, when a market or ratio experiences such a major breakdown, the recovery does not occur quickly and is unlikely to be V-shaped. In short, the structural breakdown in the global stocks-to-bond ratio suggests that global share prices will likely stay under downward pressure for some time. Bottom Line: Odds are that risk assets remain in a liquidation phase and investors should avoid catching a falling knife. The odds are also high that EM share prices in US dollar terms have another 18% downside. We reckon at those levels – where the MSCI EM equity index is around 800 – it would be safe to start accumulating EM equities, even if the global growth outlook remains mired in uncertainty. For now, we recommend playing EM on the short side. What To Do With Oil Plays Despite periodic spikes in crude prices over the past few years, we have held our conviction that oil is in a structural bear market. We doubted the sustainability of the OPEC 2.0 arrangement, arguing that Russia would not cooperate with Saudi Arabia in the long term. Russia did cooperate much longer than we had expected, temporarily supporting oil prices. Ultimately, Russian President Vladimir Putin abandoned the cartel late last week, and the Saudis have hit back with massive price discounts amid large output increases. Consequently, oil prices have crashed and are presently oversold (Chart I-9). Given the uncertainty related to both the global growth trajectory and the Covid-19 epidemic, the only way for investors to gauge a market bottom is to continuously examine valuations, technicals and market internals. However, there will be no rapprochement between the Saudis and the Russians for some time. Given the drop in demand amid sharp increases in supply, crude oil prices may well slide further. Since July 11, 2019, we have been recommending a long gold/short oil and copper trade (Chart I-10). This position has generated a large 40% gain. Today, we are taking profits on this trade. Instead, we are replacing it with a new position: long gold/short copper. Chart I-9A Long-Term Profile Of Oil Prices Chart I-10Book Profits On Long Gold / Short Oil And Copper Trade   Among oil plays, we have been overweight Mexico and Russia within EM, both in fixed income and equity universes. That said, for absolute return investors, we have not been recommending unhedged long positions in either Mexico or Russia because of our expectation of a drop in oil prices and the ensuing broad-based EM selloff. Regarding Russia, for investors who were looking to gain exposure to local currency bonds, we have been recommending that they hedge this position by shorting oil since November 14, 2019. This recommendation has paid off well, and we are closing this position with a 26% gain. We will be looking to buy Russian local bonds unhedged in the weeks ahead. Chart I-11Relative Performance Of Russian And Mexican Domestic Bonds Is Facing Near-Term Headwinds In Mexico, we have also been reluctant to recommend naked exposure to local currency or US dollar bonds because of our bearish view on oil and the risk of large outflows from EM that would hurt the peso. Indeed, the oil crash and outflows from EM have led to a plunge in the Mexican currency. Instead, in Mexico we have been recommending betting on yield curve steepening. The proposition has been that short rates are anchored by a disinflationary backdrop and tight fiscal policy in Mexico while the long end of the curve could sell off in a scenario of capital outflows from EM. As with Russia, we are monitoring Mexican markets and are looking to recommend buying domestic bonds without hedging the currency risk in the weeks or months ahead. Bottom Line: We are taking profits on our long gold/short oil and copper trade. Oil prices may stabilize, but risks are still skewed to the downside. In the near term, the relative performance of Mexican and Russian stocks and local currency bonds versus their respective EM benchmarks could be undermined by capital outflows from EM in general and these countries in particular (Chart I-11). Nevertheless, both nations’ macro fundamentals remain benign, and their fixed-income and equity markets will outperform their EM peers in the medium term. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes   1     Calculated as ratio of equal-weighted average of total return indices of cad, aud, nzd, brl, idr, mxn, rub, clp & zar relative to average of jpy & chf total returns (including carry); rebased to 100 at January 2000. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations