Emerging Markets

Special Report

Highlights The ruling African National Congress will be difficult to displace in upcoming elections given the large economic role it plays in the public sector and in low-income households. Low growth outcomes will continue as the government navigates allocating state funds more efficiently, amid rising public debt, weak macroeconomic fundamentals and a fresh undertaking of fiscal austerity. The African National Congress is primed to claw back some lost voter support with President Ramaphosa at the helm. But Ramaphosa will also put a stop to fiscal austerity ahead of the 2024 general election. Our new South Africa Geopolitical Risk Indicator captures moments of significant political risk in the past and currently signals that the country is facing a geopolitical and political risk level last seen in 2016. The political status quo will remain for now, which is positive for investors. But China’s economic troubles and South Africa’s eventual need to inflate away its debt pose long-term risks for investors. Feature In the wake of COVID-19, South Africa has witnessed an increase of civil unrest. Severe looting in July 2021 only lasted a couple of days and was mostly contained to the central and eastern parts of the country but it nearly brought the country to a stand-still. The imprisonment of former President Jacob Zuma and a harsh lockdown amid resurging COVID-19 cases at the time fanned flames already lit by long-standing structural economic issues. The country has been stuck in a low growth trap for several years and government is facing constraints from rising debt levels. Yet the ruling party (the African National Congress, or ANC) will be difficult to displace in upcoming municipal elections and future general elections. It plays a large role in the public sector and low-income households depend heavily on government grants. Moreover, the ruling party also enjoys a “liberator” status, with voters pledging support to the ANC based on the party’s historical achievement of playing a major role in ending the apartheid regime. Unless the party implodes from within – possible but unlikely – the ANC will continue to rule, which is also the best outcome for investors at the current juncture. Low Growth Continues Amid High Debt The South African economy was straining before the pandemic and will continue to underperform going forward. Plagued by rampant corruption, misused state funds, and a lack of political leadership, the public sector has dragged on growth for several years now. Coupled with poor productivity in the primary and secondary sectors, South Africa’s economy faces headwinds which will affect future growth outcomes for years to come (Chart 1A).   In the mining sector, the country’s top foreign exchange earner, output has been in a structural decline since 1980 even as the country has benefited from several commodity price booms (Chart 1B). More recently, Ramaphosa’s 2018 investment drive to rebuild South African industries has failed to galvanize a turnaround.1 Manufacturing is much of the same story as mining. Output has been in decline from 1990 and has reached its lowest level since mid-1960 (Chart 1C). The National Union of Metal Workers have recently undertaken a protracted strike that has lasted three weeks already – with many industry bodies citing the dangers of irreparable harm to production and severe job losses should the strike continue for much longer. Other factors such as intermittent electricity outages across the country will subtract from productivity going forward. Chart 1BPrimary Sector Productivity In Structural Downfall... Chart 1C...Followed By The Secondary Sector Chart 2Public Debt Is Ballooning Fast From longstanding misuse of public funds comes the ballooning public government debt (Chart 2). Our colleagues over at the BCA Emerging Markets Strategy team have assessed the state of fiscal policy and debt in South Africa and the outlook is bleak. The government is currently pursuing fiscal austerity measures to rein in debt. However, these measures are unlikely to be enough and will become politically untenable over time. Otherwise, to stabilize debt, policy makers will have to inflate their way out of debt servicing costs or increase fiscal spending to boost nominal GDP growth. According to the 2021 budget speech, real spending is projected to contract each year over the next three years. This marks the first cut to nominal noninterest government expenditure in at least 20 years. Other items such as health care will see spending cuts over the next three years and remain lower than 2013 levels. Social protection and job creation initiatives will also see spending cuts. Another large budgetary item that will see spending cuts is the public sector wage bill. The government has reiterated its commitment to curb this growing expense. Recent negotiations with civil servants saw only a 1.5% wage increase over the next year compared to an average growth rate of 7% over the last five years. Chart 3Government Spending Important To Demand Austerity measures will lower public sector demand and ultimately growth. However, if successful, they will bolster both potential economic growth and the ruling party’s support. The problem is the timing of the general election in 2024. The economic backdrop in the country remains weak. Assuming more civil unrest takes place, government finances will be burdened with picking up the cost again and appeasing the masses through higher social spending. Austerity measures will presumably be relaxed ahead of the 2024 vote. Government debt needs to be curtailed considering that debt servicing costs are the second largest expenditure item of the country’s national economic budget. But given how large the public sector contributes to local demand (Chart 3), the ANC will see pushback by trade unions and those that have been in its growing employ. However, pushback will not necessarily translate into an irreversible breakdown of political support. Trade unions have been part and parcel of the ANC since the party’s inception. The party will have to strike a balance to keep the unions on its side. Bottom Line: Under Ramaphosa’s leadership, government austerity measures will continue at least over the short to medium term but will most likely be balanced to ensure the ANC maintains control through the 2024 elections. Ramaphosa Strengthens The ANC Civil unrest is nothing new in South Africa. There have been various displays of civil unrest and riots in recent years. The most recent civil unrest led to over 300 civilian casualties, the deadliest since the apartheid era. However, casualties were mostly a result of public stampeding civilian-on-civilian violence. The government did not play a major role in these deaths compared to the Marikana massacre of 2012.2 Even then, despite the ANC facing backlash from the immediate community, the party suffered no major fallout nationally. Recent unrest was more widely spread this time around and serves as an early warning signal to the ANC that social risks are high and not abating. But as things stand, these events will not displace the ANC from power. Such events would need to occur more regularly across the entire country, for them to pose a real threat to ANC rule. Since taking the helm of the ruling party in late 2017, Ramaphosa is viewed a lot more favorably than his predecessor, Zuma, by most South Africans. Ramaphosa is more business friendly, transparent, and is at least trying to weed out corruption in government. The public view of Ramaphosa’s handing of COVID-19 has been improving. Even supporters of the Democratic Alliance, the official opposition, and the Economic Freedom Fighters, a radical far-left party, have shown a large improvement in their approval of Ramaphosa’s handling of the pandemic (Chart 4). The Economic Freedom Fighter’s growth has largely been driven by disgruntled ANC supporters in recent years. Seeing supporters of the Economic Freedom Fighters improve their approval of Ramaphosa is positive for the ANC in upcoming elections. The ANC has two significant backstops to any deep erosion of their voter base: feudalism and social grants. Feudalism is defined as a socioeconomic structure in which people work for a leader of a community or tribe who in return, give them protection and use of land. It still runs deep in South Africa and across its cultures and tribes. It gives life to the ANC, a strong base that the Economic Freedom Fighters will always have a tough time chipping away at. Rural voters matter most to the ANC and mostly live under feudal rule. Tribal leaders and village chiefs play a major part in everyday life for rural people. There is overwhelming support among these leaders for the ANC because the ruling party provides them with access to land, among other things. By contrast, the Democratic Alliance and the Economic Freedom Fighters have had little success in penetrating these barriers. Support for both of these parties is driven by urban dwellers. The overarching royal Zulu family is the biggest factor contributing to feudalism. The Zulu family will always support the ANC and ensure their people do too. The Zulus are the largest tribe of black South Africans and have significant interests in the ANC maintaining power, such as access to land and financial resources. Obviously they have historic ties to the founding of the ANC and past leaders of the ANC, including Zuma (but not Ramaphosa). Additionally, the tripartite alliance of trade unions, the South African Communist Party, and the ANC has always ensured that workers represented in labor unions across the country voted for the ANC. The candidate elected president of the ANC, and ultimately the country, has always had the backing of trade unions, represented by the largest, the Congress of South African Trade Unions.3 The Congress of South African Trade Unions has never waived their support of the ANC in any elections and have shown no interest in supporting any other parties. The social grants system is the second backstop. The ANC provides social payments to 22% of the population, of which approximately 76% of recipients vote for the ANC (Chart 5, top panel). That’s a significant amount of the population that will forego a large part of their economic livelihoods if they vote for the Economic Freedom Fighters or another party to rule the country. In the current climate of COVID-19, foregoing government grants in order to vote for another party will not happen. Voters are increasingly worried about losing their social grants if another party comes into power (Chart 5, bottom panel). While other parties like the Economic Freedom Fighters have promised to more than double the going social grant rate if they come to power, social grant recipients and ANC voters at large have not budged on this “promise.” A sure thing today is better than a gamble tomorrow. But, if the fiscal standing of the country teeters into a position whereby the ANC fails to meet its growing social grant liabilities, then the Economic Freedom Fighters will gain the most, even if its promises will be extremely difficult to back up. Upcoming municipal elections in November 2021 will put to the test whether the ANC will shed support like it did in the 2016 election (Chart 6, top panel). Under Zuma, the ANC’s losses were the Economic Freedom Fighter’s gains. In the 2019 general election this transfer of votes lost some momentum because of Ramaphosa’s ability to galvanize support for the ANC (Chart 6, bottom panel). The Economic Freedom Fighter’s rise has been driven by the party’s ability to berate the ANC on its systemic corruption, embodied in Zuma. With Zuma in jail and Ramaphosa cleaning up the party and government, the Economic Freedom Fighters will lose momentum in forthcoming elections.4 To the ANC’s benefit, opposition parties that won some significant metros in the 2016 municipal elections subsequently formed coalitions that have largely failed to govern well. Specifically, in the economic capital of Johannesburg, the ANC reclaimed a majority to govern the city through coalitions with smaller parties, after the Democratic Alliance and Economic Freedom Fighters governed the city following the 2016 election. While the ANC has only reclaimed one of three metros lost in the 2016 municipal elections, they have benefited from lackluster service delivery by opposition parties which has shown that there is no realistic alternative to the ANC right now.5 Bottom Line: As Ramaphosa cleans up the ANC and government, the ANC will shed less support to the EFF and look to claw back lost voters in forthcoming elections. Introducing Our South Africa GeoRisk Indicator Recent civil unrest in South Africa presents an ideal backdrop to introduce a new GeoRisk Indicator to our existing suite of thirteen indicators. Our newly devised South Africa GeoRisk Indicator captures moments of significant political risk in the past, including this year’s civil unrest, and currently signals that the country is facing a geopolitical and political risk level last seen in 2016, when President Zuma was on his way out of office (Chart 7). Chart 7South Africa Geopolitical Risk Indicator The South Africa indicator is based on the rand and US dollar exchange rate (ZAR/USD) and its deviation from four underlying macro variables that should otherwise explain its economic trend. These variables are: gold prices, emerging market equities, industrial production, and retail sales. The four variables cover South Africa’s commodity dependency, financial sector, and the supply and demand side of the domestic economy. All four variables exhibit sufficient correlation with the ZAR/USD for use in this indicator. If the ZAR/USD weakens relative to these variables, then a South Africa-specific risk premium is apparent. As with previous indicators, we ascribe that premium to politics and geopolitics, although this is a generalization, and a qualitative assessment must always be made. The indicator is effective in tracking the country’s recent history too. Events such as ex-President Zuma’s general election win in 2009, and his controversial firing of several finance ministers in late 2015, signal an increase in risk. Meanwhile, lower risk was implied when current president, Ramaphosa, was elected president of the ANC in late 2017, and later, in 2019, as president of the country. Some additional events worth highlighting include: (1) In late 2001 to mid-2002, the local currency lost significant value relative to the US dollar for several reasons. First, the 1998 Asia financial crisis continued to send aftershocks throughout the emerging markets. The ZAR was put through the ringer in forward markets by speculators on a frequent basis, buying cheaper in the spot and driving speculation in the forward market, making easy returns. This speculation was only compounded by the South African Reserve Bank’s intervention in the local currency market to curtail speculation through regulatory action. Second, money supply grew substantially from mid-2001 to early 2002, which is associated with exchange rate undershooting.6 Thirdly, adding to these factors, contagion risk from neighboring Zimbabwe, which was dealing with land seizures and food shortages at the time, played into risk aversion toward regional and South African assets. (2) Eskom, South Africa’s state-owned power utility company, implements more regular power outages amid struggles to supply rising demand. (3) Despite allegations of corruption, former President Zuma wins the ANC presidential nomination. Zuma becomes party president. (4) Former President Zuma wins the general election (5) Former President Zuma fires well-respected then finance minister Nhlanhla Nene (6) Former President Zuma fires well-respected then finance minister Pravin Gordhan (7) President Ramaphosa wins the ANC presidential nomination. Ramaphosa becomes party president. (8) Former President Zuma resigns from the presidency (9) Former US President Donald Trump tweets on white farm murders in South Africa7 (10) President Ramaphosa wins the general election (11) First COVID-19 case is reported (12) Civil unrest and looting In terms of South African assets, when geopolitical and political risk rises, investors favor alternative emerging market assets (Chart 8). In 2021, South African equities have climbed to levels last seen in 2018 on the back of an improving global growth outlook and swelling commodity prices. But recent civil unrest has seen local equities pull back a notch. If risks escalate further, local assets will continue to retreat. Chart 8Geopolitical Risk Signals Move To Alternative Bourses Investment Takeaways Table 1 provides a snapshot of equity performance, volatility, and relative valuations and momentum in South Africa compared to frontier markets, including African frontier markets, and emerging markets. Table 1South Africa And African Frontier Markets: Valuations, Momentum, Volatility Chart 9Wait And See On Frontier Markets Equity returns in South Africa have notched good gains as global growth picks up alongside rising commodity prices. On a risk-adjusted basis, however, Nigeria and Kenya are more attractive. The general aggregates of Frontier and African frontier markets are more attractive on the same basis. Price and timing wise, Table 1 shows valuations and momentum relative to other markets. South Africa is cheap but Nigeria is cheaper. On a cyclical basis, South Africa has more to offer than Nigeria. African countries such as Nigeria and Ghana are all prepped to move higher in the wake of cheaper currencies. But a widening financial crisis in China is a risk to these countries given how they have trended closely with Chinese total social financing (Chart 9). Meanwhile, Kenyan equities have outperformed. South African equities in US dollar terms have retreated somewhat following recent civil unrest and some contagion linked to China’s Evergrande crisis (Chart 9, second panel). If China secures its economic recovery, then higher commodity prices will boost miners and industrial stocks going forward. But this is not guaranteed. Upcoming municipal elections will aid investors in determining what to expect from the policy backdrop. We expect that the ANC will stabilize, i.e. not lose control of more cities, and this should throw some impetus back into local equities. Conclusion This year’s civil unrest was stark and disruptive but does not spell fundamental political destabilization or the end of ANC rule in upcoming elections. The South African economy is structurally weak and, aside from a bounceback on the post-pandemic recovery, will continue to lag its peers until the ANC and Ramaphosa get a solid grip on allocating state funds more efficiently, promoting a more friendly and stable business environment, and fighting corruption. Undertaking fiscal austerity now is not a bad thing for the ANC, but it will become an increasing political liability leading up to the next general election. Ramaphosa will have to pull the plug on fiscal cost cutting as soon as 2023, so as to allow demand to recover before voters head to the polls again in 2024. But this has longer term economic implications. Public debt will continue to rise in this case and add to debt default risk and debt servicing costs. If austerity is reinstated after elections, the South African economy will remain in a low growth trap. For now, tightening the fiscal belt is doable because of the dynamic created by the downfall of Zuma, giving support to austerity as a means of cutting back corruption, and the pandemic, which reinforces the ANC as the institutional ruling party during a time of national crisis.   Guy Russell Research Analyst GuyR@bcaresearch.com Appendix The market is the greatest machine ever created for gauging the wisdom of the crowd and as such our Geopolitical Risk Indicators were not designed to predict political risk but to answer the question of whether and to what extent markets have priced that risk. Our South African GeoRisk Indicator (see Chart 8 above) makes use of the same methodology used for all thirteen of our other indicators. The methodology avoids the pitfall of regression-based models. We begin with a financial asset that has a daily frequency in price, in this case the ZAR/USD, and compare its movement against several fundamental factors. These factors are the price of gold in US dollars, emerging market equities in US dollar terms, South African industrial production, and South African retail sales. Like our recently added Australia GeoRisk Indicator, South Africa is a commodity exporting country. South Africa is the largest producer of platinum in the world, and was the seventh largest gold producer by volume in 2019. Gold is South Africa’s largest export and the ZAR has a strong historic correlation to gold prices.8 Hence we use gold prices instead of platinum, which is less well correlated. South Africa also has a deep financial market, with lose capital controls and easy flow of funds. When sentiment toward EM equities is high, the ZAR benefits, and hence our inclusion of emerging market equities. On the supply and demand side of the economy, both industrial production and retail sales show a strong relationship with the ZAR. We include these as the last two variables measured in our indicator. All four variables exhibit strong correlation with the local currency. If the currency sharply underperforms them, then it must be weighed down by some risk premium, which we ascribe to domestic political and policy developments or the general geopolitical environment. Footnotes 1 In 2018, President Cyril Ramaphosa laid out a target of $100 billion in new investments over the next five years, primarily targeting primary and secondary industries. According to The United Nations Conference on Trade and Development, foreign direct investment flows into South Africa in 2020 almost halved to $2.5 billion from $4.6 billion in 2019, which was a 15% decline from around $5.4 billion in 2018. 2 The Marikana massacre was the killing of 34 miners by the South African Police Service. It took place on 16 August 2012 and was the most lethal use of force by South African security forces against civilians since 1976. 3 According to the International Labour Organization, South Africa’s union density rate was 28.1% in 2016. Strikingly, the public sector union density rate was approximately 70.1% compared to 29.1% in the private sector. 4 In June 2021, ex-President Jacob Zuma was sentenced to 15 months imprisonment for contempt of court, by failing to legally attend a tribunal on corruption in South Africa. Zuma has recently been released on medical parole. 5 In the 2016 municipal elections, the ANC lost control of three major metros. Pretoria (political capital), Johannesburg (economic capital) and (Port Elizabeth, or Nelson Mandela Bay). The official opposition (the Democratic Alliance) and the Economic Freedom Fighters formed governing coalitions in all three of the lost ANC metros. Opposition coalitions have struggled to govern more effectively than what the ANC did, given how far apart they are ideologically. In Pretoria and Nelson Mandela Bay, service delivery has been poor since, in line with ANC rule prior to 2016. In Johannesburg, the ANC won back the metro by forming a coalition with several smaller parties. Opposition coalitions are still in force in Pretoria and Nelson Mandela Bay. 6 Bhundia, A.J. and Ricci, L.A., 2005. The Rand Crises of 1998 and 2001: What have we learned. Post-apartheid South Africa: The first ten years, pp.156-173. 7 Donald Trump tweets "I have asked Secretary of State @SecPompeo to closely study the South Africa land and farm seizures and expropriations and the large scale killing of farmers." The South African government have not seized any farms nor have there been any recordings of large-scale farm killings. The tweet caused a minor sell-off in local assets at the time. 8 Arezki, Rabah & Dumitrescu, Elena-Ivona & Freytag, Andreas & Quintyn, Marc. (2012). Commodity Prices and Exchange Rate Volatility: Lessons from South Africa’s Capital Account Liberalization. Emerging Markets Review. 19. Jordaan, F. Y., & Van Rooyen, J. H. (2011). An empirical investigation into the correlation between rand currency indices and changing gold prices. Corporate Ownership & Control, 9(1-1), 172-183.

Dear client, In addition to this week’s brief report, we presented at our annual BCA conference on the challenges to the US dollar’s reserve status. If you missed the session, please contact your account representative for a replay. Kind regards, Chester   Highlights The gold/silver ratio is relapsing anew. This has historically been a bearish omen for the dollar. Many petrocurrencies have lagged the rise in oil prices, and offer a very attractive carry. Go long a basket of oil producers (NOK, RUB, MXN and COP) versus the euro. Currency volatility is too low, and is bound to rise. Stay long CHF/NZD on this basis. Remain tactically long EUR/GBP as a play on slight policy convergence between the UK and the euro area. Feature Chart I-1Being Short The Dollar Has Hurt This Year Investing in currencies is tough. One of the reasons is that the currency market is the melting pot of a confluence of catalysts. These range from relative growth dynamics, policy divergences, sector biases that dictate portfolio flows and politics, among many other factors. Our bias has always been that acting on perfect information is a highly improbable feat because we are not insiders. As such, in April 2020, we designed a rules-based model to see if, over time, currencies could be traded purely based on publicly available information. Our results, grounded on the fundamental basis that has defined the BCA approach, was a positive surprise (Chart I-1). Armed with this conviction, this week’s bulletin is focused on a few themes we have held and trading opportunities around these. In a nutshell, a positive bias on any currency can be calibrated on a good macro catalyst, a valuation cushion, and going against the consensus. An Inflation Hedge On A Reflationary Boom It is becoming more evident that inflation might prove stickier than most policymakers expect. This is bad news for real interest rates. Negative real rates have been historically positive for gold and other precious metals. Within this sphere, our preference has been silver. First, silver is a reflationary metal and tends to do well when global growth is strong and the dollar is falling (Chart I-2). Since the onset of the COVID-19 crisis, silver has had a near-perfect negative correlation with the dollar (Chart I-3).   Chart I-2Gold, Silver, And the Dollar Chart I-3Silver Is A Good Reflation Play There are also an economic and valuation cases to be made for silver. Economically, silver is a byproduct of both copper and zinc mining, which have had supply-side disruptions. Meanwhile, a boom in goods demand has boosted the demand for silver, which mainly goes into electronics production. The combination is leading to a deficit in the silver demand/supply balance (Chart I-4). On the valuation side, the fair value for the gold/silver ratio is near 50, which has been the mean since the 18th century (Chart I-5) Chart I-4Silver Has A Supply Deficit Chart I-5Gold Is Expensive Relative To Silver   Fundamentally, both silver and gold are precious metals. Just like gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for currency wars and fiat money debasement. However, the gold/silver ratio tends to peak when the environment migrates from reflationary to inflationary (Chart I-6). As such, silver is a good inflationary hedge amidst a reflationary boom. This brings us to the sweet spot for silver. Even if global growth remains tepid over the next few months, a lot of the bad news is already reflected in silver prices, especially vis-à-vis gold. Relative speculative positioning hit a low of -25% as a percent of open interest. Relative sentiment on gold is 10% higher relative to silver. This is bullish from a contrarian perspective (Chart I-7). Chart I-6Silver Does Well With Rising Inflation Chart I-7Silver Has Been Shunned Relative To Gold Higher Currency Volatility Currency volatility is likely to rise in the coming months. Options markets offer many opportunities to trade this theme, but being long CHF/NZD is an attractive bet as well (Chart I-8). The kiwi is backed by a very hawkish central bank that will likely dial back its rhetoric amid much uncertainty about the growth outlook. Meanwhile, the kiwi is expensive according to most of our models. As such, we expect the kiwi to rise vis-à-vis the greenback over a cyclical horizon, but we feel it is at risk on a tactical basis. Chart I-8CHF/NZD Tracks Dollar Volatility The RBNZ has decided to introduce house price considerations into its mandate. While this is politically palatable, it is economically unviable as rising real estate prices are a global phenomenon. The risk is that a hawkish RBNZ tilts the economy over, especially if the current environment is stagflationary. As such, we are short the NZD at the crosses. Our long AUD/NZD position is based on policy convergence between Australia and New Zealand and our long CHF/NZD is based on rising currency volatility. We were stopped out of our long CHF/NZD position and are reinitiating the trade today. A Play On Higher Oil Prices Oil prices are likely to stay elevated in the coming months. But even if they relapse, a bet on being long oil producers versus consumers could still prove profitable. Petrocurrencies have lagged the performance of oil tremendously (Chart I-9). This is especially the case when looking at oil-producing countries versus oil-consuming ones. RUB, COP, and MXN are trading well below their implied levels relative to the USD, EUR, and RMB. Chart I-9Petrocurrencies Will Catch Up With Oil Price A lot of oil players are seeing a rebound in their economies, as their populations get vaccinated. Russia, Mexico, Brazil, and Colombia all have lower new COVID-19 incidences, compared to earlier this year and versus the US (Chart I-10). As a result, economic activity is rebounding in these countries relative to the US (Chart I-11). Our bias is that the dollar will resume its cyclical bear market in the coming months. This will push up many petrocurrencies, as the path of the dollar usually dictates the performance of many developed and emerging market currencies (Chart I-12). Chart I-10A Drop In Infections Outside The US... Chart I-11...Leading To A Recovery In Growth       Chart I-12Petrocurrencies Track The Dollar The big risk is a slowdown in China, which will have a meaningful impact on oil demand. The Chinese credit impulse correlates quite well with commodity and oil currencies, and therefore, should the impulse slow further, this will meaningfully impact import demand (Chart I-13). Our bias is that there is little downside to the credit impulse in China, while the imperative to stimulate the economy could be rising. So far, the authorities have been able to ringfire the crisis with no meaningful capital outflows (Chart I-14). Chart I-13China Slowdown A Risk... Chart I-14...But No Systemic Risk Yet   On the sentiment and valuation fronts, the case for petrocurrencies is more compelling. Starting with valuation, all of our models show many petrocurrencies as deeply undervalued. On a real effective exchange rate basis, the MXN, COP, and BRL are trading well below historical averages (Chart I-15). On the sentiment front, it is true that many petrocurrencies have lagged the increase in oil prices amid domestic demand concerns. This is bound to change as populations get vaccinated and their economies reopen. More importantly, many petrocurrencies sport very attractive real rates (Chart I-16). If our bias on a dollar decline proves correct, then the carry will be an added bonus. As such, we recommend going long a basket of RUB, COP, and MXN against the euro Chart I-15Most Petrocurrencies Are Cheap Chart I-16Petrocurrencies Have An Attractive Carry   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The US economy remains relatively robust: Retail sales came in at 1.8% month-on-month in September, well above consensus of an 0.8% increase. Sentiment in the US is drifting lower, according to the Michigan survey. The current conditions component of the index slipped from 80.1 to 77.9 in October. The sentiment component also fell from 72.8 to 71.4. Portfolio flows into the US remained strong with net TIC inflows of $US 126bn. Both housing starts and building permits rose in September. Ditto for existing home sales, that increased from 5.88mn to 6.29mn. The US dollar DXY index fell this week. The general tone to markets has been risk on, which has led to less demand for the safe-haven dollar. Meanwhile, according to CFTC data, speculators are very long the dollar which is bearish from a contrarian perspective.   Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data was mixed this week: New car registrations fell by 23% year-on-year in September. The trade balance came in at €11.1bn, a robust number but below expectations of a €14.2bn surplus. Consumer confidence keeps deteriorating in the euro area amidst the energy crisis. The euro was up 0.2% this week. EUR/USD has had a wild ride in recent weeks, having breached below 1.16. That said, the tides are turning in favor of the euro. Speculators are short the currency, and interest rate expectations for the euro area are bombed out relative to other developed markets. This provides room for positive surprises.  Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Condominium sales fell be 6.7% year-on-year in September. Trade remains robust. Exports rose by 15% year-on-year, while imports surged by 38.6% year-on-year. Supermarket sales increased 3.2% year-on-year in September. The yen rose 20bps this week. We were bullish the yen around 109, and even more bullish at current levels. The two things that have thrown this view offside are 1) an abrupt rise in US yields, that has attracted Treasury bids from Japanese investors and 2) profit taking by foreign investors who did catch the Japan outperformance in August. On the other side of the coin, the yen is now one of the most shorted G10 currencies, and Japanese data has been so poor relative to the rest of the G10 that some measure of catchup is due. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The key data release out of the UK this week was the inflation report: Headline CPI came in at 3.1% year-on-year in September, in line with expectations. Core CPI came in at 2.9% year-on-year in September, in line with expectations. RPI an PPI came in at 4.9% and 11.4% respectively. The pound rose by 0.3% this week. The UK is dealing with and energy and inflation crisis, similar to the rest of the world. This is bringing forward expectations of a rate hike by the BoE, which we believe would be the wrong approach should inflation subside. We are bullish sterling on a cyclical horizon, but are also long EUR/GBP tactically as a play on a policy convergence between the BoE and the ECB. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The was scant data out of Australia this week: The services PMI rebounded strongly in September, from 45.5 to 52. The manufacturing PMI remained robust, rising from 56.8 to 57.3 in October. As a result, the composite PMI improved from 46 to 52.2. The AUD rose 0.6% this week. The AUD is sitting on a coiled spring and ripe for a rebound. First, the energy crisis is bullish for Australia as it is one of the largest coal and natural gas exporters. Second the AUD is cheap, especially on a terms of trade basis. At the crosses, we are long AUD/NZD as a play on these trends. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: CPI exploded higher, rising 4.9% in the third quarter. Credit card spending was down 12.9% year-on-year in September. The NZD rose by 1.2% week. The inflation report out of New Zealand unsettled markets, pushing up bond yields significantly and propping the currency. Given the RBNZ has a mandate to consider house prices in policy settings, this has led to bets of more aggressive policy tightening in New Zealand. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced. This provides room for disappointment. We are long AUD/NZD on this basis. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been robust: The CPI report was buoyant. Headline came in a 4.4%, core-trim came in at 3.4%, core-median was 2.8% and core-common was 1.8% year-on-year. Foreigners continue to favor Canadian securities. Inflows for August rose to C$26.3bn, well above a prior print of C$14.2bn. The Business outlook survey from the Bank of Canada was robust in the third quarter, but thew future sales outlook did fall from 47 to 9, a sharp deterioration. The CAD was flat this week. On a cyclical basis, the CAD is backed by robust oil prices, and orthodox central bank that will raise rates to curb high inflation and real estate speculation, and an economy that remains on a recovery path. As such, our bias is that the path of least resistance for the CAD is up. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Swiss economy is on the mend: Total sight deposits were flat at CHF 714bn in the week ended October 15. Exports rose 0.4% month-on-month in September, while imports fell 0.8% month-on-month. The money supply rose 3.2% in September, in line with the August print. CHF rose by 0.5% this week. CHF remains a good hedged against rising currency volatility, which we believe will materialize on a cyclical horizon. That said, the swiss franc will lag the euro and other European currencies, if our view of a pickup in growth next year proves correct. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The trade balance improved from NOK 42.6bn to NOK 53.7bn in September. The NOK was up 0.7% this week. High oil prices are a boost for the NOK, especially with the opening of the energy pipeline with the UK. We also favor the NOK on valuation grounds. Stay short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There was scant data out of Sweden this week: The unemployment rate fell from 8.5% to 8.2% in September. The SEK rose 15 bps this week. We are short both EUR/SEK and USD/SEK as reflation plays. The SEK will rise very quickly should the Chinese credit impulse bottom, a likely event in our view. Meanwhile, the central bank will end QE this year and could bring forward expectations of a rate hike. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Special Report

Highlights As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers Chart 6BSouth Asian Economies Tend To Be Net Importers India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks Chart 10South Asia Is Young And Will Age Slowly   Chart 11Social Complexities Are High In Afghanistan & Pakistan A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? Chart 18South Asia: The New Epicenter For Nuclear Activity While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions