Developed Countries

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Chart I-13Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Underweight We remain bearish on the prospects of the S&P real estate sector as the pandemic will continue to severely bruise REITs. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25%. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel). A fresh stimulus bill could come to the rescue, but recent news of President Trump halting negotiations jeopardizes chances for near-term relief. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels). Bottom Line: We remain underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO. For more details, please refer to this Monday’s Weekly Report.

Highlights Long-term investors who can tolerate volatility should buy SEK/USD for a potential 20 percent upside. Short-term investors who cannot tolerate volatility should buy CHF/USD. The dollar’s short-term moves are a perfect mirror-image of the global stock market. US and euro area long-duration bond yields will ultimately converge… …and the euro area’s huge trade surplus with the US will vanish. Fractal trade: Underweight European retailers versus market. Feature Chart of the WeekSEK/USD Is 20 Percent Undervalued Relative To The Sweden/US Bond Yield Differential The demand for a foreign currency serves one of four purposes: To buy goods and services denominated in the foreign currency. To buy long-term investments denominated in the foreign currency, also known as foreign direct investment (FDI). To buy shorter-term financial investments like bonds and equities denominated in the foreign currency, also known as portfolio flows.1 To buy currency reserves denominated in the foreign currency. What Sets The Broad Level Of EUR/USD? Looking at the euro, three of the four components of demand tend to change relatively slowly. The net foreign demand for euro area goods and services is not particularly volatile. Neither is FDI. Demand for euro reserves also tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.  All of which means that the usual driver of demand for euros are portfolio flows (Chart I-2). Chart I-2Euro Area Portfolio Flows Have A High Amplitude Portfolio flows are of two main types: fixed income and equity. However, in the euro area, fixed income portfolio flows usually have the much higher amplitude (Chart I-3). The reason is that most savings are invested in fixed income assets. For example, German households hold 80 percent of their assets in fixed income, cash, or close proxies. This explains why the stock of government fixed income securities in the euro area is almost twice as large as the market capitalisation of all the euro area’s stock markets (Chart I-4). Chart I-3Euro Area Fixed Income Portfolio Flows Have A Higher Amplitude Than Equity Flows... Chart I-4...Because Euro Area Fixed Income Is The Dominant Asset-Class What causes fixed income flows to flood out of the euro area one moment and back in the next? The answer is the expected change in interest rates. The main issue is not the exact timing of short-term interest rate changes. Instead, it is the so-called terminal rate: the average interest rate over the very long term, proxied by the long-duration bond yield. Fixed income investors gravitate to the bonds with the highest potential returns adjusted for currency hedging costs or likely currency moves. In the euro area, fixed income portfolio flows have a higher amplitude than equity flows. When the expected interest rate in the euro area declines relative to that in the US, it diminishes any further price upside of euro area bonds compared with that of US T-bonds. Hence, fixed income investors shift out of the less attractive euro area bonds into US T-bonds. The outflow continues until it has depressed EUR/USD to a level where the potential upside to the exchange rate becomes symmetrically more attractive. At this new lower level for EUR/USD, the fixed income portfolio outflow stops because a new equilibrium has been established. International fixed income investors have less upside from the euro area bond price, but they now have symmetrically more upside from the cheaper EUR/USD – and the two factors cancel out. Chart I-5 provides powerful evidence of this dynamic. For the past 15 years, the broad territory in which EUR/USD trades has been a close function of the euro area/US long-duration bond yield spread.3 A zero yield spread equates to EUR/USD in the broad territory of 1.35 with every +/-100 bps equal to +/- 15 cents. Hence, the current yield spread of -100 bps equates to EUR/USD trading in the broad territory of 1.20. Chart I-5The Euro Area/US Bond Yield Differential Sets EUR/USD... Interestingly, the euro area/US trade imbalance is also a close function of the bond yield spread. This confirms that the euro area’s massive trade surplus with the US is the direct result of the massive imbalance in relative monetary policy – which depressed EUR/USD and boosted the euro area’s relative competitiveness. Put simply, at a narrower (and more normal) bond yield spread, the euro area’s trade surplus with the US would largely vanish (Chart I-6). Chart I-6...And Thereby It Sets The Euro Area/US Trade Imbalance The Euro Area/US Yield Spread Is Likely To Narrow Further The long-term evolution of EUR/USD – as well as the associated trade imbalance – hinges on the long-term evolution of the euro area/US long-duration bond yield spread. Will this spread widen or narrow? At a narrower bond yield spread, the euro area’s trade surplus with the US would largely vanish. From the euro area side, the answer is easy. The spread cannot widen, it can only narrow. With the ECB policy interest rate already expected to be stuck at its lower bound indefinitely, down is not an option. From the US side, the spread could go either way, at least mathematically. However, it is our high conviction view that in the long term it will narrow. The Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric. The central bank has told us that it will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. Hence, when the slightest further deflationary shock comes – and sooner or later it will – US long-duration bond yields will converge with those in the UK and Japan in one of two ways. Either the Fed will follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or the Fed will follow the Bank of Japan in formally implementing yield curve control (Chart I-7).   Chart I-7The US Bond Yield Will Converge With The Others Buy SEK/USD For The Long Term, Buy CHF/USD For The Short Term Other European economies also exhibit the same strong link between their exchange rates with the dollar and their bond yield spreads with the US. In the case of Sweden, there is an attractive opportunity. SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread. Hence, the long-term case for owning SEK/USD does not even require the yield spread to narrow from where it stands today. Of course, if the spread did narrow by a further 50 bps, the potential upside would approach 30 percent (Chart of the Week). SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread.  Nevertheless, for short-term investors, there is an important caveat. While fixed income portfolio flows drive the long-term values of European currencies versus the dollar, equity portfolio flows become dominant in periods of market stress. During such dislocations, equity flows tend to flee to perceived haven assets and markets, many of which are denominated in dollars. As a result, the dollar rallies. The compelling proof is that over the past year, the dollar has traded as a perfect mirror-image of the global stock market (Chart I-8). Chart I-8The Dollar In 2020 = A Perfect Mirror-Image Of The Stock Market In Europe, the haven currency is the Swiss franc. Hence, while SEK/USD fell by 10 percent during this year’s market turbulence, CHF/USD remained unperturbed. Furthermore, CHF/USD is also undervalued relative to its relationship with the Switzerland/US bond yield spread.4 Albeit, the undervaluation is more modest, at around 6 percent (Chart I-9). Chart I-9CHF/USD Is Modestly Undervalued Relative To The Switzerland/US Bond Yield Differential The conclusion is that long-term investors who can tolerate volatility should buy SEK/USD for its greater upside. Whereas short-term investors who cannot tolerate volatility should buy CHF/USD for its greater safety. Fractal Trading System* This week we note that the recent strong outperformance of European retailers is vulnerable to a trend reversal, and especially so if the pandemic resurges. Accordingly, the recommended trade is underweight European retailers versus the market (which can be implemented as EXH8 versus Euro Stoxx 600). The profit target and symmetrical stop-loss is set at 4.2 percent. Chart I-10European Retailers Vs. Market The rolling 1-year win ratio now stands at 56 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 In this discussion, portfolio flows include short-term speculative flows. 2 For example, when the Swiss National Bank broke the franc’s peg with the euro in early 2015, it abruptly stopped buying euro reserves. 3 The euro area bond yield is the issue-weighted average of the euro area’s constituent sovereign bond yields. A good approximation of the euro area’s issue-weighted average is the French bond yield.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Neutral - Downgrade Alert Absent another fiscal package, banks risk digesting a new wave of credit defaults, further increasing their loan loss provisions as pandemic wounds remain open. Importantly, according to the latest Fed data, small banks1 are at the forefront of sloppy lending activity, warning that those weaker banks have higher exposure to defaults than large banks.2 Small bank C&I loan growth reached a whopping 50% per annum growth rate (second panel). Commercial real estate (CRE) loans are also expanding at a higher rate in small banks compared with large banks (third panel). With regard to concentration, small banks have been making inroads in feverishly doling out loans versus large banks. The former now comprise 40% of total C&I loan books (the largest credit category, bottom panel) and 2/3 of CRE loans – the second largest loan category with $2.4tn outstanding. Inevitably, some loans will sour because of the pandemic and the longer it takes Congress to pass a fresh stimulus bill the higher the pain for banks. One way out of this mess will likely be via much needed industry consolidation. As a reminder the US still has 4,400 banks. Bottom Line: We remain neutral the S&P banks index, which is also on our downgrade watchlist since early September. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.    Footnotes 1 Small banks are defined as all commercial banks excluding top 25 banks ranked by domestic assets. 2 Large banks are defined as top 25 commercial banks ranked by domestic assets.