Developed Countries

Special Report

Highlights The dollar has entered a multi-year decline. However, in the very near term, we are at risk of a tactical bounce, which should be in the order of 2%-4%. Eventually, the DXY should hit 80 in 2021. This will lift the euro towards 1.35. The best-performing currency in 2021 will be the Norwegian krone. The Swedish krona will be a close second. The story for 2021 will also shift from broad dollar weakness to playable themes within the currency market. This entails more differentiation among currency losers and winners. Our ranking model suggests USD, NZD, and CHF will be the underperformers. The value-versus-growth debate will be one theme that will emerge as an important driver of currencies. Exchange rates for countries with a heavy weighting of value stocks in their domestic bourses will outperform.  Currencies of oil-producing countries will also outperform those of oil-consuming ones. The Japanese yen remains a viable portfolio hedge for 2021. Gold and silver will rise in 2021, but silver will outperform gold. Remain short the gold/silver ratio, which was our top trade in 2020. Feature Our key conclusions from last year’s outlook were as follows:1 Go short the DXY index with a target of 90 and a stop loss of 100. The top-performing G10 currencies in 2020 will be the NOK and SEK. Remain short USD/JPY as portfolio insurance. The path to a lower yen is via an overshoot, as the Bank of Japan will need a shock to act more aggressively. A weak dollar will support  gold prices. Gold will also benefit from abundant liquidity and persistently low/negative real rates. EUR/USD should touch 1.18, while GBP/USD will retest 1.40. Chart 1The US Dollar Is Breaking Down Most of these calls have panned out as we initially expected. Granted, we did not forecast the pandemic, and the first half of 2020 torpedoed much of our expectations. But we were quick to reimplement a lot of these trades throughout the year. EUR/USD has just kissed the 1.20 mark, while GBP/USD is a whisker below 1.35, even though there has not yet been a full resolution to the Brexit imbroglio. The best-performing developed market currency this year has been the Swedish krona, while the Norwegian krone and Australian dollar are up almost 30% from their March lows. Even the Japanese yen has appreciated by about 4% against the US dollar this year. In a nutshell, 2020 has been a story about broad dollar weakness (Chart 1). This has been rooted in three fundamental pillars: Unprecedented liquidity injections by the Federal Reserve, especially in terms of addressing the offshore dollar shortage. The world is now awash with dollars, as the Fed remains the most aggressive central bank in printing domestic currency. This has compressed the US’ interest rate advantage vis-à-vis  the rest of the world. A strong and synchronized rebound in global growth, as we slowly emerge from the depths of the pandemic. As a counter-cyclical currency, the dollar has suffered. This is both a combination of Asia having been able to keep the pandemic under wraps and focus on reopening its economy, as well as a pickup in manufacturing activity around the world. Fiscal stabilizers have been able to contain a more severe contraction in global consumption. Economies more levered to Chinese growth have seen a pickup in their economies, especially versus the US. This has supported capital flows back into these economies, buffeting their currencies in the process. Much of these trends will continue into next year. However, 2021 will be a year of differentiation rather than broad-based dollar weakness. What this means is that the dollar will still decline in 2021, but more money will be made at the crosses as playable themes begin to pan out. Meanwhile, in the very near term, the dollar is due for a technical reset. The Dollar In A Market Reset The dollar rarely rises or declines in a straight line, and most indicators suggest that the dollar is deeply oversold. Having broken below major trendlines, the DXY index is now sitting at the same critical spot where we suspected it would begin to see some technical resistance. Chart 2A Surge In Bullish Positioning For EUR/USD Chart 3Risk: The Dollar And Equity Markets In fact, it has been remarkable that the dollar has not risen so far, given that November has been a seasonally strong month for the dollar since the 1970s, and that the dollar has tended to stage meaningful rallies into year-end since the GFC. From a positioning perspective, sentiment on the anti-dollar (the euro) is quite ebullient (Chart 2). Such positioning has usually been associated with a correction in the EUR/USD cross and a tactical bounce in the dollar. There are three reasons why we could experience a tactical bounce in the dollar: The greenback has had a near-perfect inverse correlation with risk assets, and the latter are due for a reset after a strong month in November (Chart 3). Sentiment on stocks is quite fervent, as measured by the American Association of Individual Investors and the equity put-to-call ratio. The pandemic is still raging in many countries (Chart 4). While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Real rates have started to rise again in the US, compared to the rest of the world. Real rates remain much lower in the US, but the small improvement in both nominal and real yields will curtail some foreign outflows from the US Treasury market (Chart 5A and 5B). Chart 4Risk: Covid-19 Still Prevalent, But Cresting Chart 5ARisk: Interest Rate Differentials Moving In Favor Of The US Chart 5BRisk: Interest Rate Differentials Moving In Favor Of The US As we discussed with Mr. X this week, the DXY has about 2%-4% upside, but not much more. For one, we no longer have the liquidity issues that handicapped global markets in March this year. The outstanding swap lines between major central banks and the Federal Reserve is close to zero, suggesting that most foreign official entities have ample access to dollar liquidity (Chart 6). This was also a signal in 2009 that the dollar liquidity shortage was behind us. While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Second, the Fed has also been the most aggressive central bank in increasing its supply of its domestic currency, as we have argued above. Today, interest rates around the world are at zero. Therefore, the onus is now shifting to central bank balance sheet policy (and/or forward guidance) to communicate the future path of interest rates. Chart 7 shows that other G10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has been hurting the dollar and benefiting other currencies Chart 6Dollar Liquidity Crisis Addressed Chart 7The Fed Is Stimulating The Most Third, US growth is set to lag the rest of the world in 2021. The IMF expects global growth to rebound by 5.2% in 2021. This will be driven by emerging markets (such as China, at 8%) but also Europe, at 5.2%. The US is expected to lag, with growth at 3.1%. Relative growth between the US and the rest of the world has been an important driver of the dollar over the last few years (Chart 8). If US growth lags over the next few quarters, it will be a headwind to the dollar. Chart 8The Dollar And Relative Growth An Attractiveness Ranking For Currencies As the dollar declines in 2021, the Scandinavian currencies remain most primed to benefit. Chart 9 ranks the G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone is especially attractive as a 2021 play. Chart 9The Scandinavian Currencies Are Very Attractive More specifically, the Scandinavian currencies have borne the brunt of the dollar bull market that began in 2011, and could see quick reversals as we enter into a multi-year dollar decline (Chart 10). Exchange rates tend to be extremely fluid in discounting a wide set  of economic data, and in the case of Sweden, in discounting the outcome for global growth. With EUR/SEK and USD/SEK still at levels close to their 2008 highs, the room for mean reversion remains quite wide.  Chart 10Buy Some NOK and SEK On Weakness Chart 11The NOK And Oil Markets The Norwegian krone is also primed to benefit from the reopening of economies, particularly through the terms-of-trade channel. As an oil producer, Norway benefits from rising oil prices. This is why the Norwegian krone has been closely correlated with the relative performance of the global oil and gas sector (Chart 11). The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. More importantly, the attractiveness ranking allows us to easily devise trading strategies at the crosses. In our portfolio, we are long NOK/EUR, CAD/NZD, EUR/CHF, and JPY/USD. We are looking to buy the Scandinavian currencies on a 2% pullback. EUR/USD As The Anti-Dollar The most liquid beneficiary of dollar downside will be the euro. As we posited in our report last month, beyond near-term weakness, EUR/USD could touch 1.50 over the next few years.2 Below are the conclusions of the report: The euro has been driven over the last few years by the relative growth performance between the Eurozone and the US (Chart 12). The IMF expects euro area growth to bounce by about 5.2% next year, compared to 3.1% in the US. Much of the rise will be due to a surge in investment in the euro area, especially driven by pent-up demand in the peripheral countries. Chart 12EUR/USD And Relative Growth From the 1960s up to the Great Financial Crisis, trend productivity growth was around 2.2% in the US and 2.8% in the euro area. However, since 2009, productivity growth has been 0.6% per year in the euro area and 1.1% in the US (Chart 13). In other words, the European debt crisis has substantially subdued productivity growth in the region. As a thought experiment, if we assume European productivity growth plays catch up over the next decade, it will be roughly 1.6% higher in Europe relative to the US. Cumulatively, that is a rise by over 20%. Given that the euro is undervalued by over 10%,3 this pins the euro well above 1.50. Ultimately, European growth is cyclically tied to export growth. And with a huge concentration of cyclical sectors – such as financials, industrials, materials and energy – in European bourses, the euro tends to be largely driven by procyclical flows. Rising inflows into European bourses will be a positive catalyst for the euro. Chart 13Could European Productivity Surprise To The Upside? The euro has been lagging other cyclical assets like copper or global stocks (Chart 14). This suggests that the current breakout has been a catch-up phase. While we are likely to consolidate gains in the very near term, the euro should ultimately head higher. Our 2021 target for EUR/USD is 1.35. Chart 14The Euro Is Still Lagging Copper Currencies And The Value Versus Growth Debate The debate about the performance of value versus growth will have a significant bearing on currencies in 2021. We discussed this topic in depth in our special report last summer.4 In a nutshell, getting the value versus growth call right could be key to targeting the currencies likely to outperform in 2021. The debate about the performance of value versus growth will have a significant bearing on currencies in 2021.  Table 1 shows that value sectors have been heavily concentrated in countries with more cyclical currencies such as the Australian dollar, Norwegian krone, Swedish krona, and Canadian dollar. It has also been the case that the performance of value versus growth has tended to lead the US dollar by about a year or so. Table 1Sector Weights Across G10 Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case where value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Chart 15 shows that a basket of the CAD, NOK, AUD, and SEK (heavily weighted in cyclical sectors) relative to the CHF (heavily weighted in growth sectors) has tracked a global value/growth basket pretty closely. Given the massive underperformance over the last decade, room for mean reversion in value stocks is immense and meaningful. This will lead to powerful inflows into currencies such as the CAD, NOK, SEK, and AUD. Another playable strategy at the crosses will be US versus non-US growth. For example, the Canadian economy is more economically linked to the US than, say, the Norwegian economy. As a result, CAD/NOK has tended to track the DXY index quite well (Chart 16). And so, while both the Canadian dollar and the Norwegian krone will rise in 2021, the CAD should greatly underperform NOK. Chart 15Value Versus Growth And Currencies Chart 16A Cheaper Way To Play Dollar Downside Oil Consumers Versus Oil Producers One reason CAD will also underperform NOK has been the tectonic shift in oil markets. In short, the NOK benefits more from oil prices than the CAD, given that it is less reliant on US oil imports. There has been a disconnect between the price of oil and the performance of petrocurrencies over the last decade. During much of the early 2000s, petrocurrencies outperformed along with rising oil prices. However, from the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar (Chart 17). We have written about this at length, and the key reason is that the US is now the largest oil producer in the world. As a result, while rising oil prices are bullish for petrocurrencies, being long versus the US dollar is no longer an appropriate strategy. From the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of the pandemic. Transport constitutes the largest share of global petroleum demand. As economies reopen, oil demand should inflect higher. However, playing this trend requires an adjustment: Being long a basket of oil producers versus consumers, rather than the US dollar. Chart 18 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with  oil prices and has outperformed a traditional petrocurrency basket Chart 17Petrocurrencies Versus Oil Chart 18Oil Producers Versus Oil Consumers In our portfolio, we are long a basket of CAD, NOK, COP, RUB, and MXN against the euro. We intend to tactically play oil upside throughout 2021 via this new strategy. On JPY And CHF Chart 19The Yen And The Dollar Are Inversely Correlated In an environment where the dollar is in a broad-based decline, most currencies will do well, as was the case this year. This is also the case for safe-haven currencies, such as the Japanese yen and the Swiss franc. But as we argued with Mr. X earlier this week, there are even more compelling reasons to hold the yen in an FX portfolio. First, the yen is cheap. Falling prices in Japan over the years have tremendously improved the fair value of the yen on a PPP basis. Second, Japan has one of the highest real rates in the developed world. So, outflows from JGB’s are going to be curtailed, while inflows might actually accelerate. And finally, both the DXY and USD/JPY are positively correlated, meaning when the dollar declines, the yen rises, but less so than other currencies. This correlation tends to shift during crises, when the yen generally appreciates more than the dollar (Chart 19). This places the yen in a very enviable “heads I win, tails I don’t lose too much” position.  The Swiss franc is likely to fare worse than the yen. First, it is more expensive, and the fact that deflation is becoming more prominent in Switzerland will force the Swiss National Bank to fend off any additional currency strength. A Final Word On Gold, Silver, And Precious Metals We agree with our commodity strategists that gold is due for a tactical bounce.5 Investors had piled into gold on the bet that a raging pandemic, combined with unprecedented monetary and fiscal stimulus, was a potent cocktail for currency debasement and inflation. With positive vaccine news on the horizon, these trades are being violently unwound. A flushing out of stale longs is very healthy in our view, since our bullish thesis has never been dependent on the pandemic in the first place. Here are the reasons: Almost every major economy now has negative real interest rates. While within the foreign exchange sphere, it is relative interest rate policy that matters, the global landscape is extremely fertile for upside in gold prices. Gold has a long-standing relationship with negative interest rates, even though the correlation has shifted over time (Chart 20). The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income generating assets such as gold. And while odds are on the side of yields  creeping higher from current low levels, this will still be bullish for gold, if driven by rising inflation expectations. Chart 20Real Rates And Gold Support for the dollar is fraying at the edges. For the first time since the end of the Bretton Woods system, central banks are becoming net purchasers of gold. Central bank purchases are extremely potent in any bull market, since historically, central banks have been indiscriminate buyers. Foreign central banks have been amassing tremendous gold reserves, almost to the tune of the total annual mine output. This diversification into gold has occurred mostly via the dollar (Chart 21). Jewelry demand is a significant chunck of gold purchases, and rising emerging market currencies have improved their purchasing power for gold. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different. Chart 21Gold And Diversification In a nutshell, we believe we have entered an assymetic reality for gold prices. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and speculation. This might be the reason why gold is decoupling from the traditional variables that drive its price. Gold was rising along with the dollar for much of 2019.  As gold rises in 2021, the true winners will be the other precious metals, especially silver6 and platinum. As such, a hedged trade likely to continue being profitable is short gold versus silver. As gold rises in 2021, the true winners will be the other precious metals, especially silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 22). This is simply because silver tends to rise and fall more explosively than the price of gold. The reason is that the silver market is thinner and more volatile, with futures open interest much smaller than that of gold. Meanwhile, silver’s larger industrial use benefits from new industries such as solar power and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Chart 22Gold Versus Silver And The Dollar Chart 23GSR: A Long Term Profile Second, when gold tends to make new highs (as it did in 2020), silver tends to follows suit as well. That is why over the centuries, the GSR has tended to mean-revert (Chart 23). That means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both  gold and palladium prices (Chart 24). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters.7 Chart 24Platinum Is Attractive Concluding Thoughts Chart 25FX Trading Model Our currency positions, as we enter 2021, largely reflect the themes and ideas developed above. Our full trade table is available on page 19. These include: The DXY will bounce to 95, but then retrace back to 80 over the course of 2021. An attractiveness ranking reveals the most appealing currencies are NOK, SEK, and JPY, while the least attractive are CHF, USD, and NZD. We are positive on both gold and silver, but prefer the latter. We are short the gold/silver ratio at a level  of 80, with a target of 65. One point we have not discussed in this report is our trading model, which continues to perform well. This models remains short the USD. We will continue to enhance this model in the coming years, as we incorporate more of our thought methodology into it (Chart 25).8   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2020 Key Views: Top Trade Ideas," dated December 13, 2019. 2 Please see Foreign Exchange Strategy Special Report, "EUR/USD: Towards Parity Or 1.50?" dated November 20, 2020. 3 Please see our Foreign Exchange Strategy Weekly Report, "Updating Our PPP Models," dated November 13, 2020. 4 Please see our Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. 5 Please see our Commodity & Energy Strategy Report, “Gold Correction Has Run Its Course,” dated December 3, 2020. 6 Please see Foreign Exchange Strategy Weekly Report, “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019. 7 Marleny Arnoldi, “Palladium/platinum substitution tech unveiled by BASF, PGM producers”, Creamer Media’s Mining Weekly, dated March 10, 2020. 8 Please see our Foreign Exchange Strategy Special Report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Underweight Last Monday we executed our S&P homebuilders downgrade alert and reduced allocation in this consumer discretionary sub-group to below benchmark. While the media has been cheering homebuilder-related data recently, the reality is that the data has been fully priced in (top & bottom panels). We expect rates to continue climbing higher, which means that the catalyst that let homebuilders run wild in the first place will be heavily weighing on the index. In more detail, the middle panel of the chart shows that the ten-year US Treasury yield (shown inverted) has likely sealed the verdict for US homebuilders when looking at the sub-group in absolute terms, which makes relative outperformance a tall order. Bottom Line: We reiterate our recent underweight in the S&P homebuilding index; the position is already up 9% since the November 23 inception. The ticker symbols for the stocks in the index are: BLBG: S5HOME – LEN, PHM, DHI, NVR.  

Our semi-annual virtual meeting with the long-standing client Ms. Mea took place on December 1. Given it is the end of the year, Ms. Mea inquired about our strategies for 2021 and reviewed the evolution of our views during 2020. Below is a transcript of our discussion, which we hope will help clients better grasp our views and analysis. Chart 1EM Relative Equity Performance And EM Currencies Versus DM ex-US Ms. Mea: Before we get to investment recommendations for next year, let’s review which of your views have worked in 2020 and which have not. Answer: From a big picture perspective, we went from being very negative on EM over the last decade to being neutral on EM risk assets in both absolute terms and relative to DM peers. Since April, we have been waiting for a pullback to go long and overweight EM, but a meaningful setback has not materialized. That said, although EM risk assets and currencies have rallied substantially in absolute terms, they have not outperformed their DM peers, as shown in Chart 1. Concerning the evolution of our strategy, as you might recall, we had to chase EM stocks higher late last year after the trade deal between the US and China created euphoria in financial markets, pushing EM assets higher. But even then, we did not change our bullish view on the US dollar and continued recommending an underweight allocation in EM versus DM in global equity and credit portfolios. In our January 23, 2020 report we contended that the risk premium in global markets was extremely low and that risk assets were extremely overbought. The following week, as news of the COVID-19 outbreak in China emerged, we recommended closing the long position in EM stocks. On February 20, we asserted that odds of a breakdown were substantial and recommended shorting EM stocks outright. We closed this position on March 19 with a substantial gain. On March 26, we argued that it was too late to sell but too early to buy. In retrospect, the latter part of this assessment was incorrect. Then, on April 23, we recommended going long duration in EM local currency bonds or buying domestic EM bonds while hedging currency risk. We recommended receiving 10-year swap rates in several EM countries. We changed our long-standing strategic bullish stance on the US dollar to bearish on July 9. Simultaneously, we closed our shorts in various EM currencies versus the greenback and recommended shorting many of these EM currencies versus an equal-weighted basket of the euro, CHF and JPY (please refer to the bottom panel of Chart 1).   We upgraded EM credit from underweight to neutral on June 4 and lifted the allocation to EM stocks from underweight to neutral on July 30. EM relative equity performance versus DM has been in a broad trading range for the whole of 2020 (please refer to the top panel of Chart 1). Chart 2Facing Technical Resistance Ms. Mea: What is your EM outlook going into 2021? Answer: The odds of a major breakout in EM equities, currencies and fixed-income markets have risen, yet there could be a shakeout before the breakout. Both EM equity and the global ex-US equity indexes have risen to their previous highs which proved to be a formidable resistance level (Chart 2). The main reasons to expect a major breakout in EM and global ex-US share prices are as follows: First, the global economy could experience periodic setbacks, but things cannot be worse than they were during the pandemic-induced lockdowns in early 2020. The deployment of vaccines is likely to improve global economic conditions in 2021, especially in hard hit services sectors. Second, asset purchases by major central banks around the world have effectively removed many securities (mostly government bonds) from the marketplace while creating an enormous supply of money (Chart 3). The upshot is that too much money is chasing fewer assets. Chart 4 illustrates this phenomenon in the case of US dollar securities. Cash in both US institutional and retail money market funds is still elevated. As a share of market value of US dollar denominated equities and bonds, the amount in US money market funds has declined but it is still above its February lows. Provided that US money market rates are zero, one can make the case for more flows from money markets into both equities and bonds. Chart 3Booming Money Supply Worldwide Chart 4How Much Cash On-SidelinesIs There Left In The US?   Finally, odds that EM equities will break above the trading range they have been in over the last 10 years have increased. As we discussed in our previous reports, EM ex-China, Korea and Taiwan have been facing hard budget constraints due to limited fiscal stimulus packages, a breakdown in their monetary transmission mechanism, and massive foreign capital outflows in early 2020. These harsh conditions have forced many companies to restructure to boost their efficiency. The banking system has been recognizing and provisioning for bad assets. Finally, some governments have adopted difficult structural reforms. These could be sowing seeds of structural transformation in these economies, in turn producing a secular bull market in their equities and currencies. As was discussed in a recent Country In-Depth report, India is one example where structural reforms stand to have a positive effect on its long-term outlook. Indonesia, Colombia, Mexico, and Brazil are other candidates that could undergo similar transformations. In a nutshell, unless the global economy craters – which has low odds – one can envision a scenario in which risk assets continue marching higher. Ms. Mea: However, you mentioned that there could be a shakeout before the breakout. What makes you say that? Answer: A potential shakeout before the breakout may occur due to the following three peaks: Peak investor sentiment: Investor sentiment is very elevated and risk assets are overbought. The ZEW global growth expectations index (a survey of analysts on DM economies) has rolled over after reaching an all-time high (Chart 5, top panel). The Sentix survey of investor future expectations has reached an apex (Chart 5, bottom panel). Importantly, net long positions in copper and net bullish sentiment on copper are at their previous highs (Chart 6). This is a plausible proxy for investor sentiment on both China and global growth. Chart 5Investor Expectations Are Elevated Edited Chart 6Investors Are Super Bullish On And Very Long Copper   Chart 7Investors Are Bullish On US Equities Finally, sentiment among US equity investors is also elevated (Chart 7). Peak stimulus: In China, both credit and fiscal stimulus will likely peak in Q4 2020, as demonstrated in Charts 8 and 9. The US and the euro area will experience a negative fiscal thrust in 2021 equal to 7.4% and 3.8% of GDP, respectively. A new fiscal package worth $1.5 trillion is needed in order for the US fiscal thrust to be neutral. As Republicans are likely to retain control of the Senate, even after Georgia’s Senate election vote on January 5, 2021, a new fiscal package larger than $500-750 billion is unlikely. On the whole, many countries in DM and EM are experiencing peak stimulus in 2020. Chart 8China: Peak Credit Stimulus Chart 9China: Peak Fiscal Stimulus   Peak manufacturing growth: We should differentiate between the top in a business cycle and an end in growth acceleration. As far as global manufacturing is concerned, we are likely currently experiencing growth acceleration at its height. Global manufacturing will continue to expand, but at a slower rate. Share prices could either rally or correct when growth begins to decelerate. The stock market reaction is contingent upon how overbought and how expensive equity prices are. The top panel of Chart 10 illustrates that the tops in the US ISM manufacturing new orders-to-inventory ratio have historically marked setbacks in global cyclical stocks. Similarly, EM share prices and industrial metals fluctuate with the EM and China manufacturing PMI (Chart 10, middle and bottom panels). Having risen sharply to very elevated levels, odds are that global and China manufacturing PMIs are probably topping out. Granted, these are diffusion indexes, and declines/rollovers in global manufacturing PMIs do not necessarily imply that a recession is on the horizon. Rather, they signal the end of the acceleration phase in a cycle. Bottom Line: Given how overbought and expensive they are, share prices might react negatively to peak stimulus. Ms. Mea: Your outlook on the Chinese economy has become more nuanced since the spring. How do you see China’s business cycle and financial markets evolving? Answer: We upgraded our view on the Chinese business cycle in late May after it had become apparent that China had again injected enormous credit and fiscal stimulus into the economy. On June 18, we upgraded Chinese stocks to overweight within an EM equity portfolio. We continue to expect decent growth numbers and reviving corporate profits in most of H1 2021. That said, authorities have been tightening monetary policy since May. Policymakers realize that China’s credit excesses have become even larger and they have been proactive in policy tightening to rein in leverage and speculative activities. The central bank has siphoned off banks’ excess reserves causing interbank rates to rise considerably (Chart 11). With a time lag, money/credit will decelerate and the business cycle will follow. We expect the Chinese business cycle to crest around the middle of 2021. Chart 10Cyclical Assets Fluctuate With Manufacturing PMIs Chart 11China: Liquidity Tightening Works With A Time Lag   The recent shakeout in the onshore corporate bond market will lead to a reduction in corporate bond issuance as investors now require higher yields to finance SOEs. In addition, banks and non-bank financial institutions have to comply with the asset management regulation by the end of 2021. This will restrict banks’ ability to expand their balance sheets and curb NBFI risk appetite. All in all, credit-sensitive sectors like capital spending and the property market will decelerate considerably in H2 2021. Provided that they make up a large share in the mainland economy, overall income growth will also slump. Concerning financial markets, if there is a selloff in Chinese stocks in the coming weeks or months, it will give way to another upleg later in H1 2021. Ms. Mea: Going forward, what will be the driving forces of EM risk assets and how will they shape up? Answer: EM risk assets – equities, credit markets and high-yielding domestic bonds – are by and large driven by three factors: (1) China’s import and commodities cycles (which often move in tandem); (2) domestic fundamentals in EM ex-China; and (3) sharp swings in US growth and the S&P500. (1) We elaborated on the intricacies of the Chinese business cycle above and will now offer a few insights on commodities prices. There has been a broad-based recovery in Chinese demand for commodities and various commodities prices have risen substantially. Nevertheless, the outlook for commodities prices is less certain going forward. Chart 12China's Booming Copper Imports Imply Inventory Accumulation In particular, copper prices have surged but the rally is only partially attributable to recovering real demand in China. Other forces, namely inventory restocking in China and financial (investor) demand, have been responsible for the massive rise in copper prices. The mainland’s imports of copper and copper products have boomed since spring, growing at a rate of 70-80% from a year ago. Meanwhile, the recovery in Chinese infrastructure investment in electricity, water, and gas – which are the largest consumers of copper – has been considerable but not extraordinary (Chart 12). This surge leads us to infer that a sizable inventory restocking cycle has been taking place in China since last spring. Such large inventory accumulation has likely been prompted by the easy availability of credit and rising copper prices. Besides, investors hold record net long positions in copper on the New York Mercantile Exchange (refer to Chart 6). In brief, as we discussed in detail in the Special Report from November 25, Chinese purchases of copper will decline even as its real demand for copper continues to expand. Oil prices are at risk of excess supply as many producers are reluctant to continue suppressing their crude output. Saudi Arabia has been trying hard to limit OPEC+ production. However, it will be increasingly difficult for it to do so. The basis is that many producers are naturally looking to maximize the net present value of cash flow from their oil reserves. Due to inflation, $45 today is worth more than $45 in five years. As and when oil producers accept that global demand for oil will stagnate as the world switches to more environmentally friendly sources of energy, they will have an incentive to produce and sell as much crude as possible at current prices. Chart 13EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices If Saudis lose control over output, they will ramp up their own production to increase their market share. Crude prices will plunge anew. The timing is uncertain, but we expect it to happen sooner rather than later. Overall, even though China’s business cycle recovery will continue in H1 2021, prices for certain important commodities like oil and copper will likely struggle. Setbacks in commodities prices will have ramifications for financial markets in resource-producing EM countries. EM currencies, as well as their sovereign spreads, correlate with commodities prices (Chart 13). (2) Domestic demand in EM ex-China, Korea and Taiwan will gradually improve but from a very low point. Many developing countries still face major hurdles, including banking systems that are struggling with non-performing loans, a looming fiscal drag, and a lack of control over the pandemic. Further, EM outside North Asia will lag behind advanced countries in procuring and deploying COVID-19 vaccines. Consequently, consumer and business confidence will be slow to recover in these countries, and their business cycle revival will continue to trail that of North Asia (China, Korea and Taiwan) and advanced economies. (3) Finally, any shakeout in the S&P500 will reverberate through EM. Having rallied considerably, North Asian equity and currency markets have already priced in a great deal of good news. In EM ex-North Asia, the level of economic activity, albeit reviving, remains low. This makes these EM ex-North Asian financial markets very sensitive to fluctuations in global/US financial markets. Chart 14EM Equities Have Been A Low-Beta Play On The S&P500 The resilience of US equity and credit markets in recent months in the face of numerous challenges has surprised us. US share prices and credit markets have not corrected meaningfully despite (1) the third wave of COVID-19 which has resulted in partial lockdowns and a deterioration in consumer sentiment; (2) the lack of a second fiscal stimulus package and (3) uncertainty surrounding the presidential elections. In retrospect, investors have been willing to buy any small dip. Interestingly, in the past three years, EM share prices outperformed DM share prices when the S&P500 sold off and underperformed when US stocks rallied (Chart 14). EM versus DM relative share prices are shown inverted on this chart. This reveals that EM stocks are not a high beta on the S&P 500 and rising US equity markets do not guarantee that EM share prices will outperform their DM peers. Overall, the outlook for EM risk assets is convoluted, warranting a neutral stance for now both in absolute terms and relative to DM. Chart 15The US Dollar Is Oversold Ms. Mea:  Where and how does the US dollar enter your analysis? Answer: The dynamics between EM and the US dollar is push-pull in nature, i.e., the causality runs both ways. EM fundamentals – that could be broadly defined as return on capital in these economies – drive their exchange rates’ trends versus the US dollar. Further, US dollar trends are also shaped by several global macro forces, including the global business cycle. The US fiscal position and monetary policy stance also drive fluctuations in the value of the greenback. Over the next several years, the US dollar will likely be in a bear market because US inflation will rise and the Federal Reserve will fall behind the inflation curve. US real rates will remain negative, which will continue to undermine the dollar’s value. All that said, the US dollar has become very oversold and investor sentiment is bearish on the greenback (Chart 15). From a contrarian perspective, the dollar might be set up for a countertrend rebound. Interestingly, after the 2016 US elections, the US dollar rallied strongly for several weeks before selling off violently. It seems that the broad trade-weighted dollar is now following a reverse pattern (Chart 16).  The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has continued weakening since. If this reverse pattern were to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 16The US Dollar Before And After 2016 And 2020 Presidential Elections Chart 17EM Stocks Are Cheap If The Structural EPS Trend Is Up In short, a long-term bear market but near-term rebound in the US dollar is consistent with our view of a shakeout before a breakout for EM equities and risk assets. Ms. Mea: What about EM equity and currency valuations? Are they not still cheap despite their recent rally? Answer: From a secular perspective, EM equities appear modestly cheap as illustrated by our cyclically-adjusted P/E (CAPE) ratio (Chart 17). However, it is vital to realize that this CAPE valuation model assumes that EPS (earnings per share) in real (inflation-adjusted) US dollar terms will revert to its long-term trend sooner rather than later (Chart 17, bottom panel). There is a lot of uncertainty regarding the structural trend in EM EPS. For the past decade – and therefore well before the pandemic – EM EPS in nominal US dollar terms has been fluctuating in a wide range (Chart 18). Not surprisingly, EM share prices have been flat for the past ten years. Further, EM EPS has massively underperformed US EPS in local currency terms for the past ten years (Chart 19). Consistently, EM share prices have underperformed the S&P 500 even in local currency terms. Chart 18EM EPS: No Growth For 10 years Chart 19EM Versus US: Relative Stock Prices And Relative EPS   As for EM currencies, the aggregate real effective exchange rate of EM ex-China, Korea, Taiwan currencies suggests that they are cheap (Chart 20). Overall, to argue that EM stocks are cheap, one should be confident that EM EPS in real (inflation-adjusted) USD terms will be expanding in the years to come (Chart 17, bottom panel). While some EM economies have undertaken some restructuring, there is currently no strong evidence to suggest that EM EPS will be in a structural uptrend. From a cyclical perspective, EM EPS will certainly be recovering in 2021 (Chart 21). However, a notable chunk of this profit recovery has already been largely priced in. Chart 20EM ex-China, Korea, Taiwan: Currency Valuations Chart 21EM Profits Will Recover In 2021   To sum up, a bet on EM share prices breaking out above their decade-long trading range implies betting on EM EPS entering a period of structural growth. Over the past ten years, EM companies have not delivered the secular growth needed to warrant higher equity multiples. We are open to the idea that structural reforms carried out in several nations will allow for higher productivity, income and profit growth. However, it is still too early to jump to that conclusion. Chart 22Will Asian Markets Finally Break Out? Ms. Mea: Where in your analysis and strategy might you be wrong? Answer: The key risks to our view are twofold: First, FOMO (fear of missing out) on the part of investors continues to propel EM risk assets higher while either their fundamentals remain mediocre or they are already very expensive. As we have shown in Chart 4, there is still a lot of US dollar cash sitting in US money market funds and these could feed the EM rally, preventing the materialization of a shakeout. Second, we might be late to recognize structural shifts in certain EM economies and, might therefore miss breakouts in those bourses. Notably, there is no single EM equity market that has clearly broken above its previous highs (Chart 22). Ms. Mea: What are your overweights and underweights for equity, currency and fixed-income portfolios? Answer: For an EM equity portfolio, our strong conviction overweights have been and remain China, Korea and Mexico. Chart 23 shows the performance of our fully-invested EM equity portfolio based on our recommended country allocation. It has outperformed the EM MSCI equity benchmark by 3.7% in 2020 and by 74% since its initiation in May 2008. The latter translates into a 4.7% CAGR outperformance versus the EM MSCI equity benchmark in 10.5 years. Critically, this outperformance has been achieved with very low volatility and small drawdowns. Chart 23Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) As for EM local bonds, we continue to recommend receiving ten-year swap rates in Korea, Malaysia, Russia, Mexico, Colombia, South Africa, China and India. We are looking for a setback in their currencies to switch to holding cash bonds, i.e., without hedging currency risk. Among EM currencies, our short basket consists of BRL, CLP, ZAR, TRY and IDR while our favored ones have been MXN, RUB, CZK, INR THB and SGD. All these country recommendations and positions as well as the one in the EM sovereign credit space (US dollar bonds) are always presented at the end of our reports (please refer to the following pages). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Don’t trust market inflation expectations or real interest rates. When inflation is near-zero, think in nominal terms not in real terms. New structural recommendation: Underweight inflation protected bonds versus conventional bonds. For the time being stay overweight stocks versus bonds, but sell stocks if the 10-year T-bond yield rises by 0.3 percent. We address four concerns about inflation raised by clients. Fractal trade: short copper versus gold. Don’t Trust Market Inflation Expectations Or Real Interest Rates Are the markets any good at predicting inflation? No, they are not (Chart of the Week). Both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds have been lousy predictors of inflation.1 We can forgive that. What we cannot forgive is how these markets derive their inflation forecasts. Chart of the Week AThe Markets Are Lousy At Predicting Inflation Chart of the Week BThe Markets Are Lousy At Predicting Inflation Expected inflation in the UK just tracks the commodity price index (Chart I-2), and expected inflation in the US just tracks the oil price (Chart I-3 and Chart I-4). This link between expected inflation and the level of commodity prices is absurd, for three reasons: Chart I-2UK Bond Markets' Expected Inflation Just Tracks Commodity Prices Chart I-3US Bond Markets' Expected Inflation Just Tracks The Oil Price Chart I-4US Inflation Swaps' Expected Inflation Just Tracks The Oil Price Inflation measures a change in a price. Therefore, inflation expectations should not track the price level of anything. Even if expected inflation is incorrectly tracking a price level, a lower price today will increase the scope for future inflation, and vice-versa. Hence, any relationship with the current price level should be an inverse relationship, not a positive relationship. Most absurd of all, how can the level of commodity prices today conceivably forecast the inflation rate five years ahead through 2026-31, as the inflation forwards seem to be suggesting? There are two important takeaways from the absurdity of inflation expectations. First, it follows that the market’s estimates of the real interest rate must also be lousy, and taken with a huge dose of salt. The market’s estimates of the real interest rate must be taken with a huge dose of salt. Second, as the market’s inflation expectations just track commodity prices, the relative performance of UK index-linked gilts versus conventional gilts just tracks commodity prices too (Chart I-5); and the performance of US TIPS versus T-bonds just tracks the oil price. Nothing more and nothing less (Chart I-6). As we expect the structural bear market in commodities has much further to run, the structural recommendation for bond investors is: Chart I-5UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices Chart I-6US TIPS Vs. T-Bonds = The Oil Price Underweight inflation protected bonds versus conventional bonds. When Inflation Is Near-Zero, Think In Nominal Terms Not In Real Terms If the market is lousy at predicting long-term inflation, then it might also be lousy at predicting the long-term nominal return on equities. After all, shouldn’t prospective inflation impact the prospective 10-year nominal return on equities? The surprising answer is no. The prospective 10-year nominal return on the stock market depends only on the stock market’s starting valuation. The 10-year nominal return on the stock market does not depend on prospective inflation, it depends only on the stock market’s starting valuation. The same relationship between the stock market’s starting valuation and prospective nominal return applied in the high-inflation 1970s and 1980s as it did in the low-inflation 2000s (Chart I-7). Chart I-7The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The reason is that the stock market’s 10-year nominal return has two components: the income through the 10 years, and the terminal value at the end of the 10 years. When inflation is high, the income component is larger, but the terminal value component is smaller – because in an inflationary environment the market will demand a higher subsequent return, requiring a lower price. When inflation is low, the opposite is true: lower income, but higher terminal value. These effects cancel out, so the result is a prospective nominal return that is independent of prospective inflation. Crucially, the required prospective return on equities in excess of bonds is also established in nominal terms. This is because the bond yield’s lower limit is nominal, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. Witness Swiss bonds this year. As the riskiness of equities and bonds converges, the required prospective nominal return on equities collapses towards the ultra-low bond yields. The upshot is that both the prospective return on equities and the required prospective return on equities should always be calculated in nominal terms, never in real terms. Right now, the high valuation of the aggregate stock market means a very low prospective nominal return, and this valuation is hypersensitive to ultra-low bond yields (Chart I-8 and Chart I-9). Chart I-8The Stock Market Is Priced To Generate A Feeble Long-Term Return Chart I-9AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Chart I-9BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time For the time being stay overweight stocks versus bonds, but as we warned two weeks ago, Sell Stocks If The Bond Yield Rises By 0.3 Percent. Four Concerns About Inflation Raised By Clients In this section, which is in question and answer format, we will address four concerns about long-term inflation that our clients have raised. 1, Isn’t the unprecedent fiscal stimulus in 2020 setting us up for inflation down the road? No, not in itself. Understand that the unprecedented stimulus is in response to unprecedented shocks to incomes that have come from the rolling waves of the pandemic. As incomes disappeared, governments provided income-substitution. As and when incomes reappear, governments will withdraw the income-substitution. Indeed, the UK government tried to withdraw its income-substitution (furlough) scheme prematurely and had to backtrack when the virus resurged. This illustrates that the unprecedented fiscal stimulus is a much-needed stabiliser of the economy, rather than a source of inflation. 2. But if governments want a bit of inflation, they can get it, can’t they?  No. Understand that inflation is a non-linear system with two states, price stability and price instability. You can shift between these two states, but you cannot get a ‘little bit of inflation’ in a controlled fashion, or hit an arbitrary inflation target like 2 percent, 3 percent, or 5 percent. This is something that we have been arguing for years, and it is comforting that some great thinkers – like (the late) Paul Volker and William White – fully support our non-linear system thesis. You cannot get a ‘little bit of inflation’ in a controlled fashion. Any government can take its economy into the state of price instability if it so chooses. Witness Turkey and Argentina. But price stability is the much better state to be in. Given that developed economies have expended decades of blood, sweat, and tears to reach the state of price stability, we think that it would be a monumental policy error to embark on the road to price instability (Chart I-10). Chart I-10Inflation Is A Non-Linear System With Two States, Price Stability And Price Instability 3. But doesn’t rampant Argentina-type inflation bail out the heavily indebted? No, not necessarily. It will only bail you out if your debt is a one-off lump sum payment in the distant future. If your debt requires ongoing refinancing, then inflation will not bail you out, because the refinancing interest rate could rise in line with, or even faster than, the inflation rate. Therefore, those highly indebted governments, firms, and households that need to refinance their debts would not benefit from rampant inflation. 4. In which case, isn’t the solution to let inflation rip while keeping interest rates depressed – so-called ‘financial repression?’ No. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of equities and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the required prospective nominal return would surge as a compensation for the higher inflation. The result being an almighty crash in stock and real estate markets. Given that the near $500 trillion combined worth of such markets dwarfs the $90 trillion global economy, the impact of such a crash would make this year’s pandemic feel like a waltz in the park. Fractal Trading System* This week’s recommended trade is short copper versus gold, given that the spectacular relative outperformance is showing fragility in both its 65-day and 130-day fractal structures. The profit target and symmetrical stop-loss is set at 10 percent. Chart I-11Copper Vs. Gold In other trades, long RUB/CZK reached the end of its holding period with a marginal partial loss. The rolling 12-month win ratio now stands at 53 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Dr. Copper has gone ballistic of late, breaking out to multi-year highs. While there is an element of speculative fervor, global growth is ascending and China’s demand for commodities remains insatiable (top panel). Copper’s recent spike signals that EUR/USD will likely decisively break above the 1.20 ceiling (bottom panel), a message that China’s immense easing corroborates as we highlighted last week. The Fed was adamant in debasing the US dollar as a way to reflate not only the US but also the global economy as we highlighted early on in the recovery in early-May. Now the Fed has passed the baton to investors and USD bears are squarely in control. The implication is that a positive feedback loop of a falling currency and rising global growth is great news for commodity producers. We expect a V-shaped recovery in the cyclicals/defensives profits on the back of the budding economic recovery the world over (middle panel). Bottom Line: Continue to prefer deep cyclicals at the expense of defensives.