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Special Report

Highlights Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Feature Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.1  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism Chart II-3USA: From Nationalism To Anti-Nationalism   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession Chart II-5World Conflicts Rise After Major Crises   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.2 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).3 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.4  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism Chart II-9US And EU Crack Down On Immigration   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).5 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  3  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  4  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left Chart I-6The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There Chart I-7Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes Chart I-9Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break Chart I-15Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Chart I-22Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism Chart II-3USA: From Nationalism To Anti-Nationalism   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession Chart II-5World Conflicts Rise After Major Crises   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism Chart II-9US And EU Crack Down On Immigration   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME:   Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2  But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion.  Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers.  To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds. The reason is that the economic landscape remains fraught with uncertainty, both politically and economically. We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and GBP along with some safe havens. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for dollar downside. The EUR/USD could touch 1.16, while still staying in the confines of a structural bear market. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Feature Chart I-1The Dollar Tries To Break Down The DXY index is punching below key support levels in an attempt to reverse the cyclical bull market in place since 2011. Our technical roadmap has been the upward-sloping channel, in place since 2018 (Chart I-1). At 96.77, the DXY index is already several ticks below the lower bound of this channel. As the breakdown becomes more broad based, especially vis-à-vis the euro, this will cement the transition from easing financial conditions to improving global growth. Cyclical currencies such as the Australian dollar and the Norwegian krone have already bounced powerfully from their March lows and have now entered the technical definition of a bull market (Chart I-2). For example, from a low of 55 cents, the Aussie is now trading at 69 cents, up 25%. As long-term dollar bears, our portfolio has benefited tremendously from this shift in market sentiment.1  Chart I-2A Report Card On Currency Performance The key question for new investors is whether the move in the dollar represents a false breakdown or the beginning of a cyclical bear market. To answer this, we are reviewing key charts and indicators to explain dollar weakness and help gauge whether it pays to enter new short positions. Explaining Dollar Weakness US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are reopening faster. As a result, economic momentum is higher outside the US. The rise in economic momentum is supporting money velocity outside the US. In other words, animal spirits are being rekindled at a faster pace abroad. In the classical equation MV=PQ,2 a rise in both M and V can be explosive for nominal output. Higher money velocity outside the US has started to attract capital inflows. This is beginning to show up in the outperformance of non-US markets. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace.  Chart I-3 shows that dollar strength throughout most of March can be partly explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. This was exacerbated by a dollar liquidity shortage, as demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. As Chart I-2 illustrates, developed market currencies have fared in pecking order of the easing in lockdown measures, with the AUD outperforming the CAD, and the SEK outperforming the EUR. Prior to the onset of COVID-19, there was a pretty tight correlation between global services relative to manufacturing activity and the dollar (Chart I-4). As a relatively closed economy, the US tended to benefit when services output had the upper hand. This time around, the service sector has been hit much harder due to social distancing measures in place, but it is also likely to have a more drawn-out recovery. For example, visits to theme parks or restaurants are unlikely to retrace back to their pre-crisis peaks anytime soon. However, construction activity, especially geared towards infrastructure or residential housing, may bounce back sooner. Chart I-3A Strong Recovery Outside The US Chart I-4USD And Manufacturing Vs Services The key message is that global manufacturing activity so far is holding up better than services, and activity is picking up faster abroad. This has historically been good news for procyclical currencies. Money Velocity And The Dollar There is increasing evidence that money velocity is being supported outside the US. For global manufacturing activity to recover, it requires a rise in animal spirits to begin to capitalize on very generous financing conditions. In this respect, there is increasing evidence that money velocity is being supported outside the US. In the euro area, the velocity of money in Germany has stopped falling relative to the US. This is a marked change from anything we have seen since the European debt crisis. More importantly, the ebb and flow of ‘V’ in Germany relative to the US has mirrored the relative path of interest rates (Chart I-5). Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for the improvement in PMIs (Chart I-6). Granted, the improvement in relative V has been driven mostly by the collapse in US money velocity. But what matters for currencies are relative trends. Once economic activity enters a full-fledged recovery, we expect US output to be hampered by the rise in the dollar over the past 18 months, while cyclical economies will be buffeted by much-cheapened currencies. This raises the prospect of much more pronounced economic vigor outside the US. Chart I-5Money Velocity Support In Europe Chart I-6Euro Area Sentiment Is Improving The ratio of the velocity of money between the US and China has tended to track the gold/silver ratio (GSR) with a tight fit (Chart I-7). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the US. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses than gold. Therefore, the recent collapse in the GSR is prescient.   Soft data confirms this trend. Both the Caixin and NBS manufacturing PMI are outperforming that in the US, and are likely to keep doing so in the coming months (Chart I-8). Chart I-7Money Velocity Support In China? Chart I-8Wide Gap Between Chinese And US Output It is important to note that while there has been some disconnect between the performance of the economy and stock prices, no such dichotomy exists in currency markets. The ratio of cyclical currencies relative to defensive ones tends to track the global PMI directionally. While this ratio is below its 2008 lows, the global PMI has bottomed at higher levels (Chart I-9). The difference can probably be explained by the fact that either domestic investors (especially retail) have been the dominant buyers of equities, and/or institutional investors have been hedging currency risk. It is true that the bounce in AUD/CHF (or other procyclical pairs) from the lows has brought it closer to technically stretched levels, and some measure of indigestion is overdue. That said, this mainly reflects mean reversion from deeply oversold levels (Chart I-10). If manufacturing activity can keep improving, and the velocity of money outside the US can pick up, this will revive capital flows into these markets, which will lead to more pronounced breakouts. Given the huge uncertainty surrounding these forecasts, we believe the risk to the greenback is currently balanced. Chart I-9Equity And Currency Markets Have Diverged Chart I-10Still Oversold Capital Flows As An Indicator The nascent upturn in a few growth indicators is also coinciding with a positive signal from equity markets. Global cyclical stocks have started to outperform defensives in recent weeks, as flows into more cyclical ETF markets are accelerating (Chart I-11). Chart I-11Inflows Into Cyclical ETFs Chart I-12Inflows Into US Assets Are Picking Up The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Indeed, the latest data show that as recent as March, net foreign inflows into US equity markets were quite strong (Chart I-12). This might explain why the S&P 500 continued to outperform during the March drawdown. In a nutshell, the outperformance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to the euro area, commodity-producing countries, and other emerging and developed market currencies (Charts I-13A and I-13B). The catalyst will have to be rising relative returns on capital outside the US, but the starting point is also extremely attractive valuations. Chart I-13ANascent Bounce In Cyclicals Versus Defensives Chart I-13BNascent Bounce In Cyclicals Versus Defensives We recently penned a report titled “Cycles And The US Dollar,” which showed empirically that US valuations have more than fully capitalized future earning streams, especially vis-à-vis their G10 peers. That said, before a cyclical bear market can fully unfold, we are watching two key indicators for dollar downside: As the Fed continues to dilute existing bond shareholders, the ratio of the US bond ETF (TLT) to gold (GLD) will be an important proxy for investor sentiment. One of the functions of money is as a store of value, and gold remains a viable threat to the dollar (and Treasurys) in this regard. A falling ratio will suggest private investors are dumping their bond holdings in exchange for harder assets such as precious metals. Recent inflows into the GLD ETF may be signaling such a shift (Chart I-14), but it will take a clean break in this ratio below 0.95 to solidify the trend. As geopolitical tensions between US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, USD/CNY is holding close to cyclical highs, but a break above will put Asian currencies at risk. This will have negative implications for developed-market commodity currencies (Chart I-15). Chart I-14Gold And USD Inflows Diverge Chart I-15Tied To The Hip EUR, GBP And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP along with some safe havens. Being short the gold/silver ratio is also a good way to play an eventual economic recovery, with the benefit of a tremendous valuation cushion. The market certainly applauded the European Central Bank’s addition of €600 billion in bond purchases, given the fall in peripheral bond spreads. The euro also bounced on the back of two factors: Chart I-16QE And EUR/USD Even with additional stimulus, the balance sheet impulse of the Fed is still larger than that of the ECB (Chart I-16). Historically, this has favored long EUR/USD positions. The compression in peripheral spreads should boost European growth as it lowers the cost of capital for countries such as Spain and Italy. This improves debt dynamics and encourages the productive deployment of capital. Technically, the EUR/USD can rally towards 1.16 while remaining within the confines of a structural bear market (Chart I-17). Beyond this point, it will be imperative for European growth dynamics to take over the baton to support a much higher exchange rate. As we mentioned earlier, the velocity of money in Germany has stopped falling relative to the US, but relative improvement is not yet enough to warrant structural positions in EUR/USD. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Since the 1980s, this three-factor model has outperformed the DXY index by a significant margin (Chart I-18). Chart I-17EUR/USD Could Touch 1.16 Chart I-18The Model Is Short DXY In June Finally, our limit-sell on EUR/GBP was triggered at 0.90 last week. While valuation favors a short position, the ramp-up in Brexit tensions is a key risk to this trade. As such, we are placing tight stops at 0.905.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: Headline PCE fell from 1.3% to 0.5% year-on-year in April. Core PCE also declined from 1.7% to 1%. Personal income surged by 10.5% month-on-month in April, while personal spending decreased by 13.6%, implying a higher savings rate. Total vehicle sales increased from 8.6 million to 11 million in May. Factory orders fell by 13% month-on-month in April. The trade deficit widened from $42.3 billion to $49.4 billion in April. Initial jobless claims increased by 1877K for the week ended May 29th. The DXY index fell by 1.1% this week, reflecting cautiously positive sentiment as many countries started to ease lockdown measures.   Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020   The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Headline inflation fell from 0.3% to 0.1% year-on-year in May, while core inflation was unchanged at 0.9%. The unemployment rate increased from 7.1% to 7.3% in April. The Markit manufacturing PMI slightly fell from 39.5 to 39.4 in May, while the services PMI increased from 28.7 to 30.5. Retail sales plunged by 19.6% year-on-year in April, following an 8.8% decline the previous month. EUR/USD appreciated by 1.4% this week. On Thursday, the ECB kept key interest rates unchanged, while announcing a further 600 billion euros increase of its PEPP facility, taking the total to 1.35 trillion euros. There was also an extension of the program till June 2021.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders plunged by 14.3% year-on-year in April. Housing starts fell by 12.9% year-on-year in April. Capital spending increased by 4.3% quarter-on-quarter in Q1. The monetary base surged by 3.9% year-on-year in May. The manufacturing PMI was unchanged at 38.4 in May, while the services PMI increased from 21.5 to 26.5. The Japanese yen fell by 1.3% against the US dollar this week. Japan lifted its nationwide state of emergency last week, however, the economy is still in deep recession as COVID-19 continues to disrupt global supply chains.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The Markit manufacturing PMI slightly increased from 40.6 to 40.7 in May. The services PMI also ticked up from 27.8 to 29. Nationwide housing prices fell by 1.7% month-on-month in May. Money supply (M4) surged by 9.5% year-on-year in April. Mortgage approvals increased by 15.8K in April, down from 56K the previous month. GBP/USD increased by 1.7% this week. The Bank of England urged banks to step up no-deal Brexit plans this week, implying that there might have been a shift in the BoE’s assumptions about the outcome of ongoing talks between the UK and the European Union. That being said, we remain bullish on the pound from a valuation perspective, but are tightening our stop loss this week.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The manufacturing index increased from 35.8 to 41.6 in May. The current account surplus increased from A$1 billion to A$8.4 billion in Q1. However, more recent trade data was less encouraging. Imports plunged by 9.8% month on month in April while exports slumped by 11.3%. The trade surplus narrowed from A$10.6 billion to A$8.8 billion. GDP grew by 1.4% year-on-year in Q1. On a quarterly basis, it fell by 0.3% compared with the last quarter in 2019.  Building permits increased by 5.7% year-on-year in April. AUD/USD appreciated remarkably by 4.5% this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. Moreover, the RBA sounds cautiously positive in its rate statement, saying that “it is possible that the depth of the downturn will be less than earlier expected.”   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Terms of trade fell by 0.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. It is the first fall since Q4 2018. Building permits fell by 6.5% month-on-month in April, following a 21.7% monthly decrease in March. NZD/USD increased by 4% this week. The fall in terms of trade was led by the decline in meat prices, including lamb and beef, from record levels at the end of 2019. Forestry product prices also fell by 3.4% quarterly in Q1. On a positive note, New Zealand is prepared to ease lockdown measures as there has been no new cases reported for nearly two weeks.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019   Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: GDP plunged by 8.2% quarter-on-quarter in Q1. The Markit manufacturing PMI increased from 33 to 40.6 in May. Labor productivity increased by 3.4% quarterly in Q1. Imports fell from C$48 billion to C$36 billion in April. Exports also declined from C$46 billion to C$33 billion. The trade deficit widened from C$1.5 billion to C$3.3 billion.  The Canadian dollar rose by 2.2% this week, alongside oil prices. On Wednesday, the BoC kept interest rates unchanged at 0.25%. It also decided to scale back the frequency of some market operations as financing conditions have improved.   Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses   Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell from 59.7 to 53.2 in May. Real retail sales plunged by 20% year-on-year in April, following a 5.8% decrease the previous month. The manufacturing PMI increased from 40.7 to 42.1 in May. GDP declined by 1.3% year-on-year in Q1. On a quarter-on-quarter basis, GDP fell by 2.6% compared with Q4 2019.  Headline consumer prices kept falling by 1.3% year-on-year in May. The Swiss franc rose by 0.5% against the US dollar this week. The 2.6% quarterly decline in Switzerland’s GDP has been the most severe since 1980, mostly led by hotels and restaurants which suffered a 23.4% fall. In addition, the consistent decline in consumer prices might lead the SNB to further step up FX intervention.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There has been scant data from Norway this week: The current account surplus increased from NOK 25 billion to NOK 66 billion in Q1. The Norwegian krone appreciated by 3.5% against the US dollar this week. Statistics Norway’s recent balance of payments report shows that the balance of goods and services surged to NOK 27 billion in Q1. Balance of income and current transfers also increased from NOK 1.9 billion to NOK 38.9 billion. Our Nordic basket against the euro and the US dollar is now 10% in the money.   Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: GDP increased by 0.4% year-on-year in Q1, down from 0.5% the previous quarter. The trade surplus increased from SEK 5.2 billion to SEK 7.6 billion in April. The manufacturing PMI increased from 36.4 to 39.2 in May. Industrial production plunged by 16.6% year-on-year in April. Manufacturing new orders also declined by 20.7% year-on-year. The Swedish krona increased by 2.5% against the US dollar this week. Sweden’s GDP grew modestly in Q1, which is better than most of its European counterparts, following its decision not to impose a full lockdown to contain the virus.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019   Footnotes 1Please see our table of trades below. 2Where M = money supply, V = velocity of money, P = price level and Q = output.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of the Monitors are now below the zero line, indicating the need for continued easy global monetary policy to help mitigate the COVID-19 recession (Chart of the Week). Central bankers have already responded in an intense and rapid fashion to the crisis, delivering a series of rate cuts, increased asset purchase programs and measures to support bank lending to businesses suffering under quarantines. All of these vehicles have helped trigger a powerful rally in global bond markets that helped revitalize risk assets as well. After the coordinated global easing response of the past few months, the optimal policy choices now differ from country to country. This creates opportunities to benefit from country allocation decisions even in a world of puny government bond yields. The overall signal from our Central Bank Monitors is still bond bullish, however – at least over the next few months until there is evidence of how fast global growth is rebounding from the COVID-19 lockdowns. An Overview Of The BCA Central Bank Monitors Chart of the WeekUltra-Accommodative Monetary Policies Are Still Required Chart 2A Bond-Bullish Message From Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). All of the Monitors are indicating intense pressure to maintain very easy monetary policies in response to the global COVID-19 recession. While the bad economic and inflation news is largely discounted in the depressed level of bond yields worldwide, there are still opportunities to position country allocations within a government bond portfolio based on the message from our Monitors (overweighting the US, the UK and Canada, underweighting Germany and Japan). All of the Monitors are indicating intense pressure to maintain very easy monetary policies in response to the global COVID-19 recession.  In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted alongside our estimate of the appropriate level of central bank policy interest rates derived using a Taylor Rule. Fed Monitor: Policy Must Stay Accommodative Our Fed Monitor has collapsed below the zero line to recessionary levels (Chart 3A) in response to the coronavirus crisis. The Fed has already delivered a series of aggressive policy responses since March to help support an economy ravaged by the virus, including: interest rate cuts; quantitative easing (QE), including buying corporate and municipal debt; and setting up lending schemes for small businesses. The lockdown of almost the entire country has helped “flatten the curve” of the spread of COVID-19, but at a painful economic cost. The unemployment rate rose to 14.7% in April, the highest level since the Great Depression, and is expected to peak at levels above 20%. The result is unsurprising: a massive increase in spare economic capacity with a threat of deflation as headline CPI inflation plummeted to 0.3% in April (Chart 3B). Chart 3AUS: Fed Monitor Chart 3BUS Realized Inflation Flirting With 0% Within the components of our Fed Monitor, weakening growth has been the main driver of the decline (Chart 3C). Our Taylor Rule estimate suggests a deeply negative fed funds rate is “appropriate”, although the Fed is likely to pursue other avenues of easing like yield curve control before ever attempting a sub-0% policy rate. Chart 3CNegative Rates Are 'Required' In The US, But The Fed Has Other Options The fall in US Treasury yields over the past few months has been in line with the decline in our Fed Monitor (Chart 3D). While the US economy is slowly awakening from lockdowns, consumer and business confidence are likely to remain fragile given the numerous risks from a second wave of COVID-19, worsening US-China relations and, more recently, social unrest. Thus, we continue to recommend an overweight strategic allocation to the US within global government bond portfolios. The fall in US Treasury yields over the past few months has been in line with the decline in our Fed Monitor Chart 3DTreasury Yields Fully Reflect Pressure For More Fed Easing BoE Monitor: Negative Rates On The Horizon? Our Bank of England (BoE) Monitor has collapsed to the lowest level in its history on the back of the severe COVID-19 recession (Chart 4A). The BoE already cut the Bank Rate to 0.1% in March, ramped up asset purchases, and introduced a Term Funding scheme to support business lending. Any additional easing from here might entail negative policy rates, which markets are already discounting. The UK unemployment rate is expected to peak around 8%, with the BoE projecting the economy to shrink by -14% this year, which would be the worst recession in modern history. Inflation has dropped sharply on the back of the dual collapse of energy prices and economic growth, ending a period of currency-fueled inflation increases (Chart 4B). Chart 4AUK: BoE Monitor Chart 4BUK Realized Inflation Is Slowing Rapidly The components of our BoE Monitor fully reflect the dire economic situation (Chart 4C), with weak growth – led by sharp falls in business confidence – driving the collapse of the Monitor more than falling inflation pressures. Our Taylor Rule estimate of the policy rate is not yet calling for negative rates, but that is because we are using the New York Fed’s estimate of r* as the neutral real rate, which is a relatively high 1.4% (by comparison, r* in the US is estimated to be 0.5%). Chart 4CNegative Rates Are Not Yet Required In The UK The sharp fall in the BoE Monitor suggests that Gilt yields will remain under downward pressure in the coming months (Chart 4D). New BoE Governor Andrew Bailey has stated that a move to negative rates is not imminent, but markets will continue to flirt with the notion of sub-0% interest rates until the economy and inflation stabilize. We maintain an overweight stance on UK Gilts. Chart 4DBoE Monitor Suggests Continued Downward Pressure On Gilt Yields ECB Monitor: Continued Monetary Support Is Needed Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy to fight the COVID-19 downturn (Chart 5A). The ECB has delivered multiple measures to ease monetary conditions, including a new €750bn bond-buying vehicle and liquidity operations to help banks maintain lending to European businesses.​​​​​​​​​​​​​​ The recession has hit the region hard, with real GDP declining by -3.8% in Q1, the sharpest fall since records began in 1995. Unemployment rates have climbed higher, although to much lower levels than seen in the US thanks to more generous government labor support programs that have helped to limit layoffs. The sharp downturn has resulted in both a surge in spare economic capacity and plunge in headline inflation to 0.3% in April (Chart 5B). Chart 5AEuro Area: ECB Monitor Chart 5BEurope Is On The Edge Of Deflation Within the individual components of our ECB Monitor, both weaker growth and near-0% inflation have both contributed to the Monitor’s decline (Chart 5C). Our Taylor Rule measure shows that the ECB’s current stance of having policy rates modestly below 0% is appropriate. Chart 5CThe ECB Needs To Keep Its Foot On The Monetary Accelerator Despite the ECB’s easing measures, and in contrast to the message from our ECB Monitor, the downward momentum in core European bond yields has been fading (Chart 5D). With the ECB reluctant to push policy rates deeper into negative territory, and with reliable cyclical indicators like the German ZEW and IFO surveys showing signs that euro area growth is starting to recover from the lockdowns, the case for even lower core European yields in the coming months is not strong. We maintain our recommended underweight stance on German and French government bonds. We maintain our recommended underweight stance on German and French government bonds. Chart 5DNo Pressure For Higher German Bund Yields BoJ Monitor: What More Can Be Done? Our Bank of Japan (BoJ) Monitor has fallen further below zero, indicating easier policy is required (Chart 6A). The BoJ has already introduced additional easing measures in the past couple of months: extending forward guidance (inflation is projected to remain below the BoJ’s 2% target for the next three years), increasing asset purchases and enhancing loan programs to small and medium sized companies. New cases of COVID-19 have slowed sharply in Japan, prompting an end to the national state of emergency last week. Importantly, the virus did not hit Japan's labor market as severely as in other developed countries. The unemployment rate did reach a two-year high in April, but is still only 2.6% (Chart 6B). Fiscal stimulus and measures to protect job losses have played a major role in preventing a bigger spike in joblessness. Even with those measures, growth remains weak and realized inflation is heading back towards deflation. Chart 6AJapan: BoJ Monitor Chart 6BJapan Nearing Deflation Once Again Looking at the components of our BoJ Monitor, contracting growth, more than weakening inflation pressures, is the bigger driver of the fall in the Monitor below zero (Chart 6C). However, our Taylor Rule estimate does not suggest that the current level of the policy rate is out of line. Chart 6CBoJ Needs More Easing (Somehow) Until The Economy Revives The BoJ’s current combined policies of negative rates, QE and yield curve control are keeping JGB yields at near-0% levels. Those policies are also suppressing yield volatility and preventing an even bigger fall in JGB yields (with larger capital gains) as suggested by our BoJ Monitor (Chart 6D). We continue to recommend a maximum underweight in Japanese government bonds in a yield-starved world. Chart 6DJGB Yields Will Be Anchored For Some Time BoC Monitor: Deflationary Pressures Intensifying Our Bank of Canada (BoC) Monitor has collapsed into “easier policy required” territory, reaching levels last seen during the 2009 recession (Chart 7A). The central bank has already introduced several easing measures to help boost the virus-stricken economy, including cutting the Bank Rate to a mere 0.25% and starting a QE program to buy government bonds for the first time ever. Before the COVID-19 outbreak, some softening of the economy was already underway. Now, after the imposition of nationwide lockdowns to limit the spread of the virus, the unemployment rate has spiked to 13% - a level last seen in the early 1980s. The result is a massive deflationary output gap has opened up (Chart 7B), with realized headline CPI inflation printing at -0.2% in April. Chart 7ACanada: BoC Monitor Chart 7BOutright Headline CPI Deflation In Canada The fall in our BoC Monitor has been driven by both collapsing economic growth and weakening inflation pressures (Chart 7C). Our Taylor Rule estimate suggests that one of new BoC Governor Tiff Macklem’s first policy decisions may need to be a move to negative interest rates. Macklem and other BoC officials have not played up the possibility of cutting rates below 0%. However, the fact that the BoC provided no economic growth forecasts in the most recent Monetary Policy Report highlights the extreme uncertainties surrounding the economic impact from COVID-19 – even with the Canadian government providing a large fiscal response to the pandemic. Chart 7CBoC Monitor Plunging Due To High Unemployment & Low Inflation We upgraded our recommended stance on Canadian government debt to overweight back in March, and the collapse of the BoC Monitor suggests continued downward pressure on Canadian yields (Chart 7D). Stay overweight. The collapse of the BoC Monitor suggests continued downward pressure on Canadian yields.  Chart 7DCanadian Yield Momentum In Line With The BoC Monitor RBA Monitor: Rate Cutting Cycle Is Done Due to a slump in export demand and a weakening housing market, our Reserve Bank of Australia (RBA) monitor has been consistently calling for rate cuts since April 2018 (Chart 8A). Australia began its easing cycle early, having delivered a total of 125bps of stimulus since June 2019, with the two most recent cuts coming directly in response to the COVID-19 crisis. As in other developed markets, the unemployment gap in Australia has widened dramatically, owing to job losses concentrated in tourism, entertainment, and dining out (Chart 8B). Although inflation briefly breached the low end of the RBA’s 2-3% target band in Q1, this will not be a lasting development. The RBA sees headline CPI deflating by -1% year-on-year in Q2/2020 and, even as far as 2022, only sees it growing at 1.5%. Chart 8AAustralia: RBA Monitor Chart 8BInflation Will Remain Stuck Below RBA 2-3% Target Although both the growth and inflation components of our RBA Monitor are below zero, the former drove the most recent decline (Chart 8C) led by consumer confidence almost touching the 2008 lows. The RBA has already responded by cutting rates to near 0%, well below the Taylor Rule implied estimate, and initiating yield curve control with a cap on 3-year government bond yields at 0.25%. Chart 8CNo Pressure For The RBA To Go To Negative Rates Overall, Australian bond yields have accurately priced in the dovish signal from our RBA Monitor (Chart 8D). With COVID-19 relatively well contained in Australia, there is less pressure on the RBA to ease further. Governor Lowe has also ruled out negative rates, which will put a floor under yields. Owing to these factors, we confidently reiterate our neutral stance on Australian government debt within global fixed income portfolios. Australian bond yields have accurately priced in the dovish signal from our RBA Monitor. Chart 8DAustralian Bond Yields Are Unlikely To Move Much Lower RBNZ Monitor: Cause For Concern After a resurgence late last year, our Reserve Bank of New Zealand (RBNZ) Monitor has declined to a level slightly below zero (Chart 9A). The RBNZ responded to the pandemic by delivering a massive -75bps cut in March, but has since left the policy rate untouched, preferring to deliver further stimulus by doubling the size of its QE program. Forward guidance is signaling that the policy rate will remain at 0.25% until 2021, but the central bank has not ruled out negative rates in the future. ​​​​​​​Although the actual unemployment numbers do not yet capture the impact of the pandemic, both consensus and RBNZ forecasts call for a blowout in the unemployment gap (Chart 9B). The RBNZ expects the steady improvement in inflation seen up to Q1/2020 to be wiped out, with headline CPI projected to remain below the 1-3% target range until mid-2022. Chart 9ANew Zealand: RBNZ Monitor Chart 9BRealized NZ Inflation Was Drifting Higher, Pre-Virus Surprisingly, the inflation component of our RBNZ Monitor is actually calling for tighter monetary policy, owing to significant strength in the housing market (Chart 9C). However, this trend is likely to reverse - the RBNZ foresees a -9% decline in house prices over the remainder of 2020. Meanwhile, growth components such as consumer confidence and employment will remain depressed, holding down our RBNZ monitor. Chart 9CGrowth, Now Inflation, Has Driven The RBNZ Monitor Lower Overall, the momentum in New Zealand bond yields seems to have overshot the message from our RBNZ Monitor (Chart 9D). However, with so much uncertainty about business investment and cash flows from key sectors such as tourism and education, it is too early to bet on an improvement in yields. We therefore maintain a neutral recommendation on NZ sovereign debt. Chart 9DNZ Bond Yields Are Unlikely To Move Lower Riksbank Monitor: Worries For The Coronavirus Mavericks Amid the global pandemic, our Riksbank Monitor has collapsed to all-time lows (Chart 10A). In its April monetary policy decision, the Riksbank opted for continued asset purchases and liquidity measures to support bank lending to companies over a move to negative rates. One of the primary concerns for the Riksbank is headline CPI inflation, which fell into mild deflation (-0.4% year-over-year) in April on the back of lower energy prices and weaker domestic demand (Chart 10B). This could spill over into a lasting decline in long-term inflation expectations if the economy does not quickly improve. Chart 10ASweden: Riksbank Monitor Chart 10BSwedish Realized Inflation Back To 0% Both the growth and inflation components of our Riksbank Monitor are calling for further easing, with the growth component now at post-crisis lows (Chart 10C). The collapse on the growth side can be attributed to historic falls in retail confidence, the manufacturing PMI and employment while the inflation component remains depressed due to low headline numbers and inflation expectations. Chart 10CThe Riksbank Hates Negative Rates, But Could Still Need Them If The Economy Worsens The sharp downward move in our Riksbank Monitor suggests Swedish bond yields should remain under downward pressure in the coming months (Chart 10D). The key factor for yields will be the effect of the relatively lax measures implemented by Sweden to combat the pandemic. Sweden saw positive GDP growth in Q1/2020 due to fewer restrictions on the economy. However, infection and mortality rates are much higher in Sweden than in neighboring countries and, as a result, Denmark and Norway excluded Sweden from their open border agreement. Continued restrictions of the sort are bearish for growth – and bullish for bonds – in this trade-dependent economy. Chart 10DSwedish Bond Yields Will Remain Under Downward Pressure   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com ​​​​​​​Shakti Sharma Research Associate ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Investment Grade Sector Valuation: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere. Global Corporate Bond Strategy: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Feature Chart 1A Swift Policy Response Has Brought Spreads Under Control Global policymakers have responded swiftly and aggressively to the COVID-19 outbreak and associated deep worldwide recession. This includes not only fiscal stimulus and monetary easing, but central banks buying corporate debt outright and providing other liquidity backstops. Coming at a time of collapsing economic growth and deteriorating corporate credit quality, these combined policy initiatives have reduced the negative tail risk for growth-sensitive assets like corporate debt. The result: a sharp tightening of corporate bond spreads across the developed markets (Chart 1). After such a large and broad-based rally, the easiest gains from the “beta” of owning corporate credit have been exhausted. Additional spread tightening is still expected in the coming months as governments begin to restart their economies after the COVID-19 quarantines start to loosen and global growth slowly begins to improve. Spreads are unlikely to return all the way to the pre-virus tights, however, as the recovery will be uneven and there is still the threat of a second wave of coronavirus infections later this year. To that end, it makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities. It makes sense for investors to begin seeking out the “alpha” in corporate debt markets by looking at relative valuations across sectors to find opportunities.  In this report, we will conduct a review of our entire suite of global investment grade corporate sector relative value models. We will cover the US, provide fresh updates of our recently published look at the euro area1 and the UK,2 while also revisiting our relative value framework for Canada first introduced last year.3 We will also apply the same corporate bond sector value methodology to a new country: Australia. In addition, we will examine value across credit tiers using breakeven spread analysis for each of these regions. A Brief Note On Our Corporate Bond Relative Value Tools Before delving into the results from our models, we take this opportunity to refresh readers on the methodology underpinning these analyses. Our sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall investment grade universe of individual developed market economies (using Bloomberg Barclays bond indices). The methodology takes each sector’s individual option-adjusted spread (OAS) and regresses it with all other sectors in a cross-sectional model. The models vary slightly across countries/regions, as the independent variables in the regression are selected based on parameter significance and predictive power for local sector spreads. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS – a.k.a. the residual from the regression - is our valuation metric used to inform our sector allocation ranking. We then look at the relationship between these residuals and duration-times-spread (DTS), our primary measure of sector riskiness, to give a reading on the risk/reward trade-off for each sector. We then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. To examine value across credit tiers, we use a different metric - 12-month breakeven spread percentile rankings. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. With the key details of our models squared away, we will now present the results of our models for each country/region, along with our recommended allocation across sectors. We also discuss our recommended level of overall spread risk for each country/region, which helps inform our specific sector weightings. A Country-By-Country Assessment Of Investment Grade Corporates US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk (DTS) to target. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation With the Fed now purchasing investment grade corporates with maturities of up to five years in the primary and secondary markets, it makes sense to take advantage of that explicit support by focusing exposures on shorter-maturity bonds. Thus, we recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates) by favoring sectors with a DTS less than or equal to that of the overall US investment grade index. The sweet spot, therefore, is the upper-left quadrant in Chart 2 - sectors with positive risk-adjusted spread residuals from the relative value model and a relatively lower DTS. Chart 2US Investment Grade Corporate Sectors: Risk Vs. Reward Chart 3US IG: More Value In The Lower Tiers On that basis, some of the most attractive overweight candidates are Cable Satellite, Media Entertainment, Integrated Energy, Diversified Manufacturing, Brokerage/Asset Managers, and Other Financials. Meanwhile, the least attractive sectors within this framework are Railroads, Communications, Wirelines, Wireless, Other Industrials and Utilities (including Electric, Natural Gas, and Other Utilities). While we have chosen to underweight much of the Energy space (with the exception of Integrated Energy) because of generally high DTS numbers, investors who are comfortable with taking on a higher level of spread risk can find some of the most attractive risk-adjusted valuations within oil related sectors. Our colleagues at BCA Research Commodity & Energy Strategy expect oil prices to continue to steadily rise in the months ahead, with Brent oil trading, on average, at $40/bbl this year and $68/bbl in 2021.4 We recommend targeting a relatively moderate level of spread risk (within an overweight allocation to US investment grade corporates). Across credit tiers, the higher-quality portion of the US investment grade corporate bond market appears unattractive, with spreads ranking below the historical median for Aaa- and Aa-rated debt (Chart 3). Conversely, Baa-rated debt appears most attractive, with spreads almost in the historical upper quartile. Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Spreads have already tightened significantly since our last discussion of euro area corporates in mid-April, with credit markets more fully pricing in greater monetary stimulus from the European Central Bank (ECB) – including increased government and corporate bond purchases. Thus, we believe it is reasonable to target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). This means that, visually, we can think about our overweight candidates as sectors that are in the top half of Chart 4 - with positive residuals from our relative value model - but close to the dashed vertical line denoting the euro area benchmark index DTS. Target a neutral level of overall portfolio DTS close to that of the benchmark index (within a neutral allocation to euro area investment grade). Chart 4Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Chart 5Euro Area IG: All Credit Buckets Are Attractive Within this framework, the most attractive sectors are Diversified Manufacturing, Packaging, Media Entertainment, Wireless, Wirelines, Automotive, Retailers, Services, Integrated Energy, Refining, Other Industrials, Bank Subordinated Debt and Brokerage/Asset Managers. The most unattractive sectors are Chemicals, Metals & Mining, Lodging, Restaurants, Consumer Products, Pharmaceuticals, Independent Energy, Midstream Energy, Airlines, Electric Utilities, and Senior Bank Debt. On a breakeven spread basis, all euro area investment grade credit tiers look attractive and rank well above their historical medians (Chart 5). The greatest value is in the upper rungs, with Aa-rated spreads ranking in the historical upper quartile; Aaa-rated and A-rated spreads almost meet that qualification as well, with Baa-rated spreads lagging a bit further behind (but still well above median). UK In Table 3, we present the latest output from our UK relative value spread model. With the Bank of England’s record expansion of corporate bond holdings still underway, we see good reason to maintain our overweight allocation to UK investment grade corporates on a tactical (0-6 months) and strategic basis (6-12 months). We are also targeting an overall portfolio DTS higher than that of the benchmark index—which we accomplish by overweighting sectors in the upper right quadrant of Chart 6. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 6UK Investment Grade Corporate Sectors: Risk Vs. Reward Chart 7UK IG: Value In All Tiers Except Aaa Based on this framework, some of the most attractive overweight candidates are Diversified Manufacturing, Cable Satellite, Media Entertainment, Railroads, Financial Institutions, Life Insurance, Healthcare and Other Financials. Meanwhile, the most unattractive sectors are Basic Industry, Chemicals, Metals and Mining, Building Materials, Lodging, Consumer Products, Food & Beverage, Pharmaceuticals, Energy, and Technology. On a breakeven spread basis, Aa-rated spreads appear most attractive while A-rated and Baa-rated spreads also rank above their historical medians (Chart 7). Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation This week, the Bank of Canada (BoC) will join peer central banks in purchasing investment grade debt via its Corporate Bond Purchase Program (CBPP). First announced in April, the program has a maximum size of C$10 billion, equal to only 2% of the Bloomberg Barclays Canadian investment grade index. Nonetheless, the BoC’s actions have already helped rein in corporate spreads. Yet given this unprecedented support from the central bank, with room to add more if necessary to stabilize Canadian financial conditions, we feel comfortable recommending an overweight allocation to Canadian investment grade corporates vs. Canadian sovereign debt, but with spread risk close to the overall index. Consequently, we are targeting sectors in the upper half of Chart 8 with a DTS close to the corporate average denoted by the dashed line. Chart 8Canada Investment Grade Corporate Sectors: Risk Vs. Reward Chart 9Canada IG: Great Value Across Tiers Our top overweight candidates are concentrated within the Financials category: Life Insurance, Healthcare REITs and Other Financials. Meanwhile, we recommend underweighting Construction Machinery, Environmental, Retailers, Supermarkets, Wirelines, Transportation Services, Cable Satellite, and Media Entertainment. On a breakeven spread basis, there is value in all credit tiers in the Canadian investment grade space, with Aaa-rated, Aa-rated, and Baa-rated spreads all in the uppermost historical quartile (Chart 9). Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation We recently recommended going overweight Australian investment grade corporate debt vs. government bonds.5 We feel comfortable reiterating that overweight stance while maintaining a neutral level of overall spread risk. As with Canada, we are looking for sectors in Chart 10 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. Chart 10Australia Investment Grade Corporate Sectors: Risk Vs. Reward Chart 11Australia IG: Favor A-Rated and Baa-Rated Credit Based on that, our top overweight candidates are Capital Goods, Consumer Cyclicals, Energy, Other Utility, Insurance, Finance Companies, and Other Financials. Meanwhile, we are avoiding sectors such as Technology, Transportation, Electric and Natural Gas. On a breakeven spread basis, Baa-rated spreads look incredibly attractive, ranking at the 99.9th percentile; A-rated spreads are also above their historical median (Chart 11). Meanwhile, the higher quality Aaa and Aa tiers are relatively unattractive. As the relevant data by credit tier are not available in the Bloomberg Barclays Indices, we have instead used the Bloomberg AusBond Indices for this particular case, which unfortunately limits the history of our analysis to mid-2014. Bottom Line: Investors should focus global investment grade corporate bond allocations along country lines, while keeping overall spread risk close to benchmark levels, over the next 6-12 months. Specifically, we favor overweighting the US (especially at maturities of five years or less where the Fed is buying) and the UK, while keeping a neutral allocation to euro area corporates. We also like Australian and Canadian corporate debt versus sovereigns in both countries. Comparing Sector Valuations Across Markets The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Looking at Table 6, we can see some clear patterns: Table 6Valuations Across Major Corporate Bond Markets Chart 12Canada, Euro Area, and UK Win Out On A Breakeven Spread Basis The most attractive sectors across the board are concentrated in the Financials space. Brokerage/Asset Managers, Insurance—especially Life Insurance - REITs and Other Financials all look well positioned. Valuations for Oil Field Services and Refining within the Energy space are also creating an attractive entry point ahead of the steady rebound in oil prices. Conversely, the most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Most interesting are the idiosyncratic stories. These are sectors which have benefited or lost in outsized ways due to the unique impacts of COVID-19 on the economy, but which also have relatively wide or tight risk-adjusted spreads across all three countries. For example, Packaging and Paper, which should benefit from the increased demand for online shopping, and Media Entertainment, which benefits from a captive audience boosting streams and ratings, both have attractive spreads. On the other hand, we have Restaurants, with unattractive spread valuations at a time where more people will choose to stay home rather than take the health and safety risks associated with eating out. The most expensive sectors are the traditionally “defensive” ones, such as Utilities, Consumer Non-Cyclicals, and even Technology, which is now debatably a defensive sector. Finally, we can also employ our breakeven spread analysis to assess value across investment grade corporate bond markets and the country level (Chart 12). Within this framework, all the regions we have covered in this report appear attractive – especially Canada, the euro area and the UK – with Australia only appearing fairly valued. Bottom Line: Our investment grade corporate bond sector valuation models for the US, euro area, UK, Canada and Australia show some common messages, as markets have adjusted to a virus-stricken world. The most attractive valuations can be found within Energy and Financials, with defensive sectors like Utilities and Consumer Non-Cyclicals looking expensive everywhere.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Buy What The Central Banks Are Buying", dated April 14, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Great White North: A Framework For Analyzing Canadian Corporate Bonds", dated August 28, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report, "US Politics Will Drive 2H20 Oil Prices", dated May 21, 2020, available at ces.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear client, In lieu of our regular weekly report next week, we will hold a webcast on Thursday at 10:00 am ET discussing both tactical and strategic currency considerations. The format will be a short presentation, followed by a Q&A session. We look forward to engaging with you. Kind regards, Chester Ntonifor Vice President, Foreign Exchange Strategy Highlights Go short the Gold/Silver ratio (GSR). Hold a basket of NOK and SEK against a basket of the dollar and euro. Go long sterling. Feature Chart I-1The Dollar And Business Cycles When constructing a basket of high-conviction positions, the starting point is usually the framework used to build the portfolio. Ours is through a three-factor lens. The first lens determines what macroeconomic environment we are operating in. Think of a four-quadrant matrix, with growth on one axis and inflation on the other. Intuitively, the dollar should do best when global growth is decelerating and inflation is falling. The climatic expression of this is a deflationary bust, when all bets are off and the dollar is king. On the other side of the spectrum, the dollar should weaken as global growth rebounds (Chart I-1). The second lens is valuation. Specifically, as the drop in cyclical currencies in a deflationary bust approach a capitulation phase, value begins to put a cushion under deteriorating fundamentals. In our previous work, we showed that foreign exchange value-trading strategies based on PPP are profitable over the long term.1  Finally, technical indicators are our third lens for two reasons. First, they are the most powerful indicators for short-term trades. Second, they act as a bridge between bombed-out valuations and a subsequent improvement in macro fundamentals. For example, a saucer-shaped bottom in a cyclical currency can usually be a prelude to a U-shaped economic recovery. A high-conviction trade is one that ticks all three boxes or is agnostic to the first but has a powerful signal from both the second and third. Using this framework, we suggest two trades this week. Go Short The Gold/Silver Ratio When looking at our four-quadrant matrix, it is clear that the dollar tends to rise during a downturn, and fall early in the cycle. Intra-cycle performance is more nuanced. With both first- and second-quarter GDP likely to contract severely around the world, growth is likely to bounce back later this year if economies stay open. This should, ceteris paribus, lead to a weaker dollar. A bearish view on the dollar can be expressed by being short the GSR. The Gold/Silver ratio (GSR) tends to track the US dollar (Chart I-2), so a bearish view on the dollar can be expressed by being short the GSR. It is well known that most of the time, bullion is inversely correlated to the US dollar, not only due to the numeraire effect but also as competing monetary standards. Given that silver tends to rise and fall more explosively than the price of gold (Chart I-3), it makes sense that the GSR should inversely track the greenback. Part of the reason for silver’s explosive – albeit lagged – response is that the silver market is thinner and more volatile, with open interest in futures about one-third of gold. Chart I-2GSR And The Dollar Chart I-3Silver Has Explosive Rallies The potency of the GSR is in its leading properties, as it provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. The GSR tends to rally ahead of an economic slowdown, then peaks when growth is still weak but financial conditions are easy enough to short-circuit any liquidity trap. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Not surprisingly, the GSR has led the rise and fall of many ASEAN and Latin American currencies that are at the forefront of manufacturing (Chart I-4). Chart I-4GSR, Latam And Asean Currencies A key assumption in a lower GSR is that the global economy fends off a deeper recession, which would otherwise sustain a high and rising ratio. But even if we are wrong and the dollar remains stronger over the next 12-18 months, the valuation cushion from being short the GSR is outstanding. The ratio broke above major overhead resistance at 100 just as the dollar liquidity crunch was intensifying, and is now staging a V-shaped reversal. Historically, these reversals tend to be quick, powerful, and extremely volatile. Unless gold is entering a new paradigm versus silver, the forces of mean reversion should pull the ratio towards 50 (Chart I-5). Chart I-5Big Downside Potential For GSR The next important technical level for silver is the $18-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, and has provided strong downside support for silver prior to that. If silver is able to punch through this zone, this will help bridge the gap between silver and gold fundamentals. Globally, the world produces 24,201 tons of silver a year and 3,421 tons of gold. That is a supply ratio of 7:1. Meanwhile, the price ratio between gold and silver is 100:1. This seems like a very wide gap, given that the physical supply of silver is in deficit. Bottom Line: We have been flagging the GSR as a key indicator to watch since last year.2 Our sell-stop on the ratio was finally triggered at 100. Place stops at 110, with an initial target of 75. Go Long Sterling, In Addition To NOK And SEK If the dollar is indeed in a renewed downtrend, the most potent beneficiaries of this move will be NOK and SEK. Our basket of long Scandinavian currencies against both the dollar and the euro has a significant margin of safety, even if we are offside on the dollar trend (Chart I-6). The euro will naturally pop on dollar weakness, but a very liquid beneficiary could also be sterling. Trade negotiations between the UK and EU are clearly breaking down. The worst-case scenario is a no-deal Brexit, in which case the pound could significantly decline. The key question would be by how much? Every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20.  The first observation is that each time the odds of a “hard” Brexit have risen significantly, the threshold for cable downside has been 1.20. The first occurrence was the aftermath of the UK referendum in 2016. The second episode was when Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-7). Intuitively, this suggests that every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20. Of course, a pandemic can change this dynamic, as we saw with the drop in cable to 1.15 in March, but this move was not isolated to sterling. Chart I-6SEK And NOK Are Attractive Chart I-7GBP Has Historically Bottomed At 1.2 While a no-deal Brexit is not our base case, it is still instructive to simulate cable downside in the case of  such an event. Given that the last time Britain majorly defected from a union was during the Exchange Rate Mechanism (ERM) crisis in the 1990s, revisiting this episode could be instructive. The episode leading to the collapse of the pound in 1992 has important lessons for today.3 Britain entered the ERM in October of 1990 in an attempt to find a stable nominal anchor. In other words, with high inflation and an overvalued currency, adopting German interest rates was expected to temper inflation and realign the real exchange rate. Fundamental models show the pound as being very cheap. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. As doubts towards the progress of a union began to rise, investors started to question where the shadow exchange rate for ERM currencies lay, especially the Italian lira and the Spanish peseta. Britain also massively stepped up its interventions in the foreign exchange market in August of that year, having to borrow excessively to increase reserves. Britain was eventually forced to suspend its membership in the ERM. Herein lies the key differences with today. Support for the euro within member countries is extremely strong. So, while EUR/GBP may have near-term upside, a destabilizing fall in the pound relative to the euro is unlikely. A substantial rise in the EUR/GBP, assuming little euro breakup risk, is a bet on the fact that not only is the pound misaligned versus the German “Deutschemark,” but it is also expensive versus the Italian “Lira” and Spanish “Peseta.” This seems unrealistic. The pound was overvalued as the UK entered the ERM, judging from its real effective exchange rate adjusted for consumer prices. A persistent inflation differential between the UK and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-8). Moreover, fundamental models show the pound as being very cheap, especially versus the US dollar on both a PPP and productivity basis. During the ERM crisis, most of the adjustment in the pound happened quickly, but a key difference is that it was unanticipated. Foreign exchange markets today are extremely fluid and adjust to expectations quite fast. From its peak, GBP/USD depreciated by 24% by end of October 1992. Peak to trough, cable has fallen by almost 30% today. Given this drop, it is hard to imagine that the probability of a no-deal Brexit is not priced into cable. The real effective exchange rate of the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in magnitude (24% in both episodes). In the event a deal is forged, the pound should converge toward the mid-point of its historical real effective exchange rate range, which will pin it at least 15%-20% higher (Chart I-9). Chart I-8Not Much Misalignment In U.K. Prices Today Chart I-9Cable Valuation Reflects Brexit Risk Bottom Line: Go long the pound as a trade but maintain tight stops at 1.20. Our limit sell on EUR/GBP was a whisker from being triggered this week at 0.9. While we will respect this level, long-term investors can start slowly shorting the cross.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, “Introducing An FX Trading Model,” dated April 24, 2020 avaiable at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report,  “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com. 3 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly negative: Retail sales fell by 16.4% month-on-month in April, following an 8.3% decrease the previous month. The preliminary Markit manufacturing PMI increased from 36.1 to 39.8 in May. The services PMI also improved from 26.7 to 36.9. The NAHB housing market index increased from 30 to 37 in May. This follows a contraction in building permits by 21% month-on-month in April and a 30% month-on-month drop in housing starts. Initial jobless claims kept rising by 2438K for the week ended May 15th. The DXY index fell by 1% this week. The DXY index has been stuck in a narrow trading range between 98.50 and 101, ever since the Fed’s swap liquidity programs were unveiled. This suggests a stalemate between weak global growth and improving financial conditions. Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: GDP contracted by 3.2% year-on-year in Q1. Employment fell by 0.2% quarter-on-quarter in Q1. The seasonally-adjusted trade surplus narrowed to €23.5 billion from €25.6 billion in March. The current account surplus fell from €37.8 billion to €27.4 billion. The ZEW sentiment index improved from 25.2 to 46 in May. The preliminary Markit manufacturing PMI increased from 33.4 to 39.5 in May. The services PMI also ticked up from 12 to 28.7. The euro increased by 1.7% against the US dollar this week. During a recent speech at the Institute for Monetary and Financial Stability Policy Webinar, the ECB member Philip R. Lane reinforced that the ECB will continue to constantly assess the monetary measures and is fully prepared to further adjust its instruments, which might include increasing the size of the PEPP. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: GDP plunged by 3.4% year-on-year in Q1. Industrial production fell by 5.2% year-on-year in March. Machinery orders fell by 0.7% year-on-year in March, following a 2.4% contraction in February. Exports and imports both fell by 21.9% and 7.2% year-on-year respectively in April. The total trade balance fell from a ¥5.4 billion surplus to a ¥930.4 billion deficit. The preliminary manufacturing PMI fell from 41.9 to 38.4 in May. The Japanese yen fell by 0.9% against the US dollar this week. The Bank of Japan announced on Tuesday that it will hold an emergency policy meeting on Friday, May 22nd, following the bleak GDP data on Monday. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: The unemployment rate slightly decreased from 4% to 3.9% in March. Average earnings including bonuses grew by 2.4% year-on-year. Headline retail price inflation fell from 2.6% year-on-year to 1.5% year-on-year in April. The Markit manufacturing PMI increased from 32.6 to 40.6 in May. The services PMI also improved from 13.4 to 27.8. The British pound increased by 0.9% against the US dollar this week. This week saw the UK selling its long-term government bonds with negative yield for the first time in history. Moreover, the BoE has also not ruled out the possibility of negative interest rates. Please refer to our front section this week for a more detailed analysis on the pound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Westpac leading index fell by 1.5% month-on-month in April. Retail sales plunged by 17.9% month-on-month in April. The preliminary Commonwealth manufacturing PMI slipped from 44.1 to 42.8 in May, while the services PMI increased from 19.5 to 25.5. The Australian dollar appreciated by 2.6% against the US dollar this week. The RBA minutes released this week noted that the Australian economy had been severely affected by the COVID-19, and most of the contraction was expected to occur in the second quarter of 2020. The current economic contraction is unprecedented in the 60-year history of the Australian economy. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The Manufacturing PMI fell from 53.2 to 26.1 in April. The services PMI also plunged from 52 to 25.9. PPI output prices increased by 0.1% quarter-on-quarter in Q1, while input prices depreciated by 0.3% quarter-on-quarter. House sales plunged by 78.5% year-on-year in April. The New Zealand dollar appreciated by 3.4% against the US dollar this week, making it the best performing G10 currency. The RBNZ indicated that the recent rate cuts have not been transferred via lower mortgage rates or lower retail rates. They have also expressed concerns about a higher mortgage default rate once the 6-month mortgage repayment deferrals expire. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Headline consumer prices contracted by 0.2% year-on-year in April, falling into deflationary territory for the first time since 2009. Core inflation fell from 1.6% to 1.2% year-on-year in April. Trade sales contracted by 2.2% month-on-month in March.  Existing home sales plunged by 56.8% month-on-month in April, following a 14.3% decrease in March. The Canadian dollar rose by 1.3% against the US dollar this week. Statistics Canada shows that in April, consumer prices deflation is led by transportation, clothing and footwear, which saw yearly declines of 4.1% and 4.4% respectively. However, consumers paid more for food due to higher demand. Rice, eggs and pork prices rose by 9.2%, 8.8%, and 9% year-on-year respectively in April. In addition, household cleaning products and toilet paper prices also surged in April. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 4% year-on-year in April, following a 2.7% yearly decrease in March. Total sight deposits continued to rise from CHF 669.1 billion to CHF 673.5 billion last week. The Swiss franc appreciated by 0.5% against the US dollar this week. Due to the COVID-19 pandemic, KOF published a new forecast for Switzerland in May, which now forecasts the economy to rebound gradually once the current lockdown restrictions are eased. However, tax revenues in Switzerland are expected to fall by over CHF 5.5 billion this year and CHF 25 billion over the next years. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Exports plunged by 24% year-on-year to NOK 58.8 billion in April. Imports fell by 10.8% year-on-year to NOK 55.5 billion. The trade surplus fell by 78.5% year-on-year to NOK 3.2 billion. The Norwegian krone appreciated by 3.2% against the US dollar this week, fuelled by the recent oil prices recovery. Statistics Norway showed that the recent plunge in exports was mostly led by crude oil, natural gas, and fish exports. Natural gas condensates exports, on the other hand, rose by 44.7% year-on-year in April. That being said, we remain long the Norwegian krone from the valuation perspective. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industry capacity fell slightly from 89.4% to 89.2% in Q1. Total number of employees grew by 0.3% year-on-year in Q1, compared with a 0.4% growth the previous quarter. The Swedish krona appreciated by 2.8% against the US dollar this week. In the latest Financial Stability Report released this Wednesday, the Riksbank highlighted that “if the crisis becomes prolonged, the risks to financial stability will increase”. Moreover, the Bank stated that they are ready to contribute by providing the necessary liquidity to help banks maintaining sufficient credit supply. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades