Europe

Highlights The use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. We estimate that this restriction could wipe out 10 percent of jobs. Hence, as government lifelines to employers are cut, expect permanent unemployment to rise sharply. 30-year bond prices will soon hit all-time highs. Bank prices will soon hit all-time lows. While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. The biggest risk to our positioning is that the pandemic suddenly ends. But our working assumption is that a credible vaccine will not be available until 2021. Fractal trade: Gold strength and dollar weakness are approaching trend exhaustion. Feature Table I-1Hospitality, Retail, And Transport Employ 25 Percent Of All Workers In many countries, face masks have become compulsory in public places where physical distancing is impractical – such as on public transport or in supermarkets. Physical distancing and face masks create a barrier either of distance or of material between your mouth and nose and other people’s mouths and noses. The worthy objective is to control the pandemic while allowing most aspects of normal life and economic activity to resume. Yet some aspects of normal life and economic activity cannot resume. To state the obvious, the use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. These activities fall under three broad categories: Social eating, drinking, talking, singing, and cheering – a category of activities which economists call ‘social consumption’. Activities that require social communication at close quarters. Such social communication is often reliant on facial expressions, which become impossible to identify at distance or under a face mask. Long-haul travel. After all, who wants to get on an aeroplane if it means wearing a face mask for 10 hours? This raises a crucial question: in an economy which prevents mouths and noses getting in proximity to others, how much activity will be destroyed? Permanent Unemployment Set To Rise Sharply Three sectors that are suffering are hospitality, retail, and transport. ‘Bricks and mortar’ retail is suffering because physical distancing limits footfall, and because discretionary shopping is often regarded as a social activity which becomes pointless with physical distancing and face masks. Using the US as a template, the three sectors sum to around 12 percent of economic activity. If we assume that physical distancing and the use of face masks forces them to operate at two-thirds capacity, then the economy will lose a tolerable 4 percent of activity. That’s the good news. Here’s the bad news. The three sectors have a high labour intensity, so they employ 25 percent of all workers (Table I-1). Meaning that even with the optimistic assumption of operating at two-thirds capacity, more than 8 percent of jobs will get wiped out. And on less optimistic assumptions, the job destruction could rise to over 10 percent. The lockdowns were an emergency and temporary response to surging infection rates. They created massive temporary unemployment, as employers put their staff on state-subsidized furlough. As the lockdowns have eased, some of the these temporary unemployed have returned to work (Chart I-1). In contrast, the introduction of physical distancing and face masks forms a longer-term strategy to control the pandemic. As already explained, an economy without mouths and noses in proximity to others will increase the amount of permanent unemployment, which is already rising sharply (Chart I-2). Chart I-1Number Of Temporary Unemployed Down... Chart I-2...But Number Of Permanent Unemployed Sharply Up To make matters worse, state-subsidized furlough schemes are winding down. In France, the scheme will continue into 2021 but with a much-reduced subsidy per worker; in Germany the Kurzarbeit scheme finishes at the end of the year; and in the UK the furlough scheme finishes in October. As government lifelines to employers are cut, expect permanent unemployment to continue its climb. And expect this high level of structural unemployment to keep depressing 30-year bond yields. The good news is that in the coming months, 30-year bond prices will hit all-time highs (Chart I-3). But given the very tight connection between bond yields and bank share prices, the bad news is that bank prices will hit all-time lows (Chart I-4). Chart I-330-Year T-Bond Price Approaches All-Time High Chart I-4Banks Are Tracking The Bond Yield The Pandemic ‘Winners’ Are Not European To understand what has been happening in the stock market this year, you don’t need to think hard. You just need to think about how you spend a typical day in the pandemic era. Here’s a typical day for me, which I hope resonates with many of you. I participate in a series of virtual meetings using Microsoft Teams. My Apple iPhone and iPad have become my most constant and most needed work companions. I do most of my shopping on Amazon. And in the evening, I relax by watching movies on Netflix. All of which constitutes a major change from a typical day in the pre-pandemic era. In the pandemic era, I have a greater dependence on, loyalty to, and usage of Microsoft, Apple, Amazon, and Netflix products and services. Assuming my experience represents the mass experience, it explains why these companies, and a few others, are the pandemic ‘winners’. In the greatest demand shock since the Depression, the profits of Microsoft, Apple, and Amazon have held up well. While the profits of Netflix are up 40 percent1 (Chart I-5). The trouble for the European stock market is that the pandemic winners are all listed in the US, where they make an outsized contribution to stock market profits. This is the main reason why European profits are down 32 percent this year, while US profits are down ‘just’ 18 percent (Chart I-6). Chart I-5The Pandemic 'Winners' Are Not European... Chart I-6...So European Profits Have Underperformed US Profits More remarkably, these four stocks explain more than half of Europe’s Stoxx 600 underperformance versus the S&P 500. Stop and reflect on that for a moment. The major European index comprises 600 stocks, and the major US index comprises 500 stocks. Yet pretty much all you need to explain the performance difference this year are four US growth defensive stocks: Microsoft, Apple, Amazon, and Netflix (Chart I-7). Chart I-7The Absence Of Pandemic 'Winners' Explains Most Of European Underperformance While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. On Valuations And Risk Premiums What about rich valuations? Since the end of 2018, the forward earnings multiple of growth defensives – defined as global technology plus healthcare – is up from 16 to 23, a surge of almost 50 percent. Stated inversely, the forward earnings yield has collapsed from 6.2 percent to 4.4 percent.  Yet over the same period, the 10-year T-bond yield has collapsed from 3.2 percent to 0.6 percent, so the gap between the growth defensive earnings yield and the bond yield has barely changed. In other words, the huge rally in absolute valuations is entirely due to the collapse in the bond yield. Put simply, if the long-term return on bonds collapses to near-zero, then the prospective returns on competing investments must also collapse to pitiful levels, justifying richer valuations (Chart I-8). Chart I-8The Collapsed Bond Yield Entirely Explains The Collapsed Earnings Yield Of Growth Defensives In this regard, we strongly dispute the popular narrative that Robinhood day traders are creating a speculative frenzy in growth defensives. Whilst the narrative sounds alluring, the facts strongly contradict it. As the charts show, we can explain all the recent price move in terms of the two fundamentals: resilient profits combined with the collapsed bond yield. One objection is that the gap between the earnings yield and the bond yield – a measure of the equity risk premium – needs to be much higher in the pandemic era. Yet as we have shown, the growth defensives are even more defensive now than they were before the pandemic, raising the reasonable rejoinder: why should the risk premium be higher for this segment of the market during the pandemic compared to before it? Moreover, the pandemic has simply accelerated structural trends that were already underway: for example, the shift to remote working and the demise of bricks and mortar retailers started well before the virus. These major structural trends will continue with or without the pandemic. Nevertheless, the biggest risk to our positioning is that the pandemic suddenly ends. In which case, growth defensives would quickly fall out of favour while old-fashioned cyclicals – like banks – would come roaring back into favour, albeit only briefly. We are closely monitoring this risk. Our working assumption is that it is not a high risk right now because a credible vaccine will not be available until 2021. In which case, structural unemployment is set to rise sharply later this year. This will depress ultra-long bond yields even more, and keep supporting an overweight to growth defensives, at least relative to other parts of the stock market. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    Based on 12-month forward earnings per share.   Fractal Trading System* This week we highlight that both the sharp rally in gold and the sell-off in the dollar are approaching a short-term trend exhaustion. A potential catalyst for such a reversal would be Covid-19 infection rates re-accelerating in Europe to create a ‘second wave’. Given our open positions in short silver and short gold versus lead, there are no additional trades this week. The rolling 1-year win ratio now stands at 60 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. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights US Dollar: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Currency-Hedged Bond Yields: For USD-based investors, US Treasuries still offer enough yield such that currency-hedged non-US government bond yields remain less appealing in most countries. The notable exceptions are Germany, France, the UK, Sweden and Japan, where both unhedged and USD-hedged yields are below comparable US yields – stay underweight those sovereign markets versus the US in USD-hedged portfolios. Currency-Hedged Corporates: For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios. Feature Chart of the WeekStart Hedging USD Exposure? The mighty US dollar (USD), which had remained impervious to plunging US interest rates and surging US COVID-19 cases, is finally breaking down. The DXY index of major developed economy currencies is down -3% so far in 2020, and nearly -10% from the peak seen in March during the worst of the COVID-19 global market rout. Other forms of currency, like precious metals and even Bitcoin, are also surging with the price of gold hitting a new all-time high yesterday. A new USD bear market would represent a major change to the global economic and investment landscape, affecting global economic growth, inflation, corporate profitability and capital flows. We will cover these topics in more detail in the coming weeks and months with the USD entering what appears to be a sustainable bearish trend. In this report, however, we tackle the most basic question for global fixed income investors in light of the new weakening trend for the USD – what to do with non-US bond holdings, and currency hedges, after nearly a decade of generating outperformance by hedging non-US currencies into USD (Chart of the Week). Say Farewell To The USD Bull Market Chart 2These Currencies Have Clearly Broken Out The latest breakdown of the USD has been broad-based across the developed market currencies, although some currencies have been faring much better. The biggest moves versus the USD have been for majors like the euro, Australian dollar and Swiss franc, all of which have clearly broken out above their 200-day moving averages (Chart 2). In fact, the 200-day moving averages for those currencies are now moving higher, indicating that the new medium-term trend for those pairs is appreciation versus the USD. Other important currencies like the British pound, Canadian dollar and Japanese yen have gained ground versus the USD, but at a much slower pace (Chart 3). This reflects some of the unique issues within those economies (ongoing Brexit uncertainty in the UK, the pause in the oil price rally in Canada and flailing growth in Japan). Yet even the Chinese yuan, heavily managed by Chinese policymakers, has seen some mild upward pressure versus the greenback (bottom panel). The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. There are numerous reasons why this is happening now and is likely to continue doing so in the months ahead: The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. The Fed’s aggressive rate cuts earlier this year – and even dating back to the 75bps of easing delivered in 2019 – have dramatically reduced the robust interest rate differentials that had previously boosted the USD and attracted global capital flows into the currency (Chart 4). This is true for both nominal and inflation-adjusted real yields. Chart 3These Currencies Are On The Cusp Of Breaking Out Chart 4Low US Rates + Better Non-US Growth = A Weaker USD Chart 5Does The USD Require A COVID-19 Risk Premium? Chart 6Relative QE Trends Are USD-Negative Chart 7The USD Is No Longer A High Carry Currency Economic growth has been rebounding from the COVID-19 shock faster outside the US. The latest round of manufacturing purchasing managers’ index (PMI) data for July published last week showed significant monthly increases in the euro area, the UK and even Japan, with only a modest pickup in the US. This boosted the spread between the US and non-US manufacturing PMI, which correlates strongly to the price momentum of the US dollar, to the highest level in nearly three years (bottom panel). The surge in new COVID-19 cases in the southern US states represents a dramatic divergence with the lower number of cases in Europe and other developed countries (Chart 5). While there are some renewed flare-ups of the virus in places like Spain and Japan, the numbers pale in comparison to the explosion of new US cases. With the most affected areas in the US already reestablishing restrictions on economic activity, the gap between US and non-US growth seen in the PMI data is likely to widen in a USD-bearish direction. The Fed has been more aggressive in the expansion of its balance sheet compared to other major central banks like the ECB and Bank of Japan. While not a perfect indicator, the ratio of the Fed’s balance sheet to that of other central banks did coincide with the broad directional moves in the USD during the Fed’s “QE-era” after the 2008 financial crisis (Chart 6). We may be entering another such period, but with a lower impact as many other central banks are also aggressively expanding their balance sheets through asset purchases. Summing it all up, it is clear that the US weakness has further to run over the next few months - and perhaps longer with the Fed promising the keep the funds rate near 0% until the end of 2022. This fundamentally alters bond investing, and currency hedging, considerations, as the carry earned by being long US dollars is now far less attractive than has been the case over the past few years (Chart 7). In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. Bottom Line: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Where Are The Most Attractive Yields Now For USD-Based Investors? Chart 8Puny Bond Yields Across The Developed Markets In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. That makes the decisions on bond allocation at the country level more challenging, as the relative yields on offer represent a tiny proportion of a bond’s overall return on a currency-unhedged basis. For example, a 30-year US Treasury currently yields 1.25%, while a 30-year German government bond yields -0.08% (Chart 8). While the decision to hold the US Treasury over the German bond should be obvious given that 133bp (annualized) yield differential, the -4.6% decline in EUR/USD seen so far in the month of July alone has already swamped the additional income earned by owning the US Treasury. This example shows why the decision to actively take, or hedge, the currency exposure of a foreign bond relative to a domestic equivalent so important for any global fixed income investor. For someone whose base currency is entering a depreciation trend, like the USD, the currency decision becomes critical – in fact, it is the ONLY decision that matters for the expected return on any unhedged bond allocation. A proper “apples for apples” comparison of the relative attractiveness of yields in different countries, however, needs to be done after adjusting for cost of currency hedging. On that basis, US fixed income assets still look relatively attractive, even in a USD bear market. In Tables 1-4, we present developed market government bond yields across different maturity points (2-year, 5-year, 10-year and 30-year) for twelve countries. In each table, we show the current yield in local currency terms, while also showing the yield hedged into six different currencies (USD, EUR, GBP, JPY, CAD, AUD). We calculate the gain/cost of hedging using the ratio of current spot exchange rates and 3-month forward exchange rates. That is an all-in cost of hedging that includes both short-term interest rate differentials and the additional currency funding costs determined by cross-currency basis swaps. Table 1Currency-Hedged 2-Year Government Bond Yields Table 2Currency-Hedged 5-Year Government Bond Yields Table 3Currency-Hedged 10-Year Government Bond Yields Table 4Currency-Hedged 30-Year Government Bond Yields Using the example of the 30-year US and German bonds described earlier, that 30-year German yield of -0.08%, hedged into USD, has an all-in yield of +0.74%. This is still well below the 30-year US Treasury yield of 1.25%. Thus, that 30-year EUR-denominated German bond is unattractive compared to the USD-denominated US Treasury, after converting the German bond to a USD-equivalent security through hedging. That relationship holds even if we were to hedge the Treasury into euros. As can be seen in Table 4, the 30-year US Treasury has a EUR-hedged yield of +0.48%, 56bps above the EUR-denominated 30-year German bond yield. Therefore, while owning the US Treasury seems like the riskier bet on an unhedged basis now with the EUR/USD appreciating rapidly, the US bond is the superior yielding bet once currency risk is hedged away. Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities. For those that prefer charts over numbers, much of the data in Tables 1-4 is shown as static snapshots of government bond yields curves in Chart 9 (for local currency, or unhedged, yield curves), while Chart 10 shows all yields hedged into USD. The charts show that there appear to be far more interesting relative value opportunities across countries at varying yield maturities now, but those gaps become smaller after hedging non-US bonds into USD. Chart 9Currency-Unhedged Global Government Bond Yield Curves Chart 10USD-Hedged Global Government Bond Yield Curves Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities, making those bonds interesting to USD-based investors that choose to either take or hedge the EUR and AUD exposure of those bonds. In Tables 5-8, we take the yield data from the previous tables and show the hedged yields as spreads to the “base yield” of each currency, which is the government bond yield for that country. For example, in Table 3, we can see that for all countries shown, the 10-year yield hedged into GBP terms produces a yield that is above that of the 10-year UK Gilt. This is true even or negative yielding German bunds and Japanese government bonds. Thus, looking purely from a yield perspective, currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Table 5Currency-Hedged 2-Year Govt. Bond Yields Spreads Within The "G-6" Table 6Currency-Hedged 5-Year Govt. Bond Yields Spreads Within The "G-6" Table 7Currency-Hedged 10-Year Govt. Bond Yields Spreads Within The "G-6" Table 8Currency-Hedged 30-Year Govt. Bond Yields Spreads Within The "G-6" Chart 11Global Spread Product Yields Are Low We can try the same analysis above for global spread products like corporate debt. Currency returns still matter for the returns on these assets, but less so given the higher outright yields offered compared to government bonds. Yields are relatively low across investment grade credit, junk bonds, mortgage-backed securities and emerging market debt after the massive rallies seen since March, but remain much higher than the sub-1% levels seen in most of the developed market government bond universe (Chart 11). In Table 9, we show the index yield (using Bloomberg Barclays indices) in both unhedged and currency-hedged terms for the main global credit sectors we include in our model bond portfolio universe. The index yields do not change that much after currency hedging costs are included, but there are some notable differences between corporate bonds of similar credit quality in the US and euro area. Table 9Currency-Hedged Spread Product Yields Specifically, for both investment grade and high-yield corporate credit, the yield in the US is higher than that seen in the euro area. This is true for both USD-hedged and EUR-hedged terms, thus making US corporates more attractive simply from a yield perspective without factoring in credit quality. Currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Looking within the high-yield universe by credit tiers, US yields are higher than euro area equivalents for Ba-rated bonds, while euro area yields are slightly higher for B-rated debt (Chart 12). Yields on lower-quality Caa-rated debt are similar, both for US yields hedged into euros and vice versa. Chart 12No Major Differences In US & Euro Area Junk Yields Within investment grade, there is no contest with US yields higher than euro area equivalents across all credit tiers (Chart 13). Chart 13US IG Yields Are More Attractive Than Euro Area IG (in USD & EUR) Summing it all up, the new trend towards USD weakness has not altered much of the relative attractiveness of US fixed income assets on a currency-hedged basis for USD-based investors. This is true even after the sharp fall in US bond yields since March. Bottom Line: In Germany, France, the UK, Sweden and Japan, both unhedged and USD-hedged government bond yields are below comparable US Treasury yields – underweight those sovereign markets versus the US in USD-hedged portfolios. For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The dollar is on the verge of a significant breakdown. If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The most recent catalyst – fiscal support in the euro zone – has been good news on the “anti-dollar” front. Agreement on the EU recovery fund has underscored a powerful centripetal force for the euro. Because it is a reserve currency, a breakdown in the dollar will amplify the global liquidity surge. This will lead to a self-reinforcing spiral of better global growth, and a weaker dollar. Our long Scandinavian currency basket and long silver versus gold positions have benefitted tremendously from the shift in sentiment. Stick with them. While our technical indicators are flagging the dollar as oversold, any bounce from current levels should be shorted.  Our FX model remains dollar bearish, and is recommending shorting the DXY for the month of August. Feature Chart I-1On A Precipice The DXY index is punching below key support levels and on the verge of a significant multi-year decline. Up until March, the dollar was trading in a narrow band (Chart I-1). With that support now breached, the next key test for the DXY index will be the 93-94 zone, defined by the upward-sloping trend line, in place since the 2011 lows. As the breakdown becomes more broad-based, especially vis-a-vis emerging market currencies, this will cement the transition from easing financial conditions to improving global growth. Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold. As Chart I-2 shows, while gold and the safe-haven currencies remain this year’s frontrunners, the more industrial metals such as silver and platinum will likely take over the baton by year end. Within the G10 universe, cyclical currencies such as the Australian dollar and the Norwegian krone are now in the technical definition of a bull market. Such a rotation usually signals a genuine and potentially meaningful breakdown in the dollar. Chart I-2The Great FX Rotation Our trade basket has benefitted significantly from the shift in market sentiment, especially being long the NOK, the SEK and silver relative to gold.  Technical indicators suggest the dollar is likely to consolidate losses in the weeks ahead. Our intermediate-term indicator is in the lower decile of its range, and speculators are very short the cross (see US dollar section on page 14). That said, any bounce should be used as an opportunity to establish fresh short positions, contrary to the “buy-on-the-dip” strategy that has worked well over the last decade.  DXY Breakdown: What Has Changed? US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are well into their reopening phases. Meanwhile, new infections in the US are proving rather sticky. As a result, economic momentum is higher outside the US. This partly explains why the euro is outperforming both the US dollar and the yen (Chart I-3). Money velocity is rising faster outside the US, suggesting animal spirits are being rekindled at a faster pace abroad (Chart I-4). This is evident in capital flows, where some non-US markets have started to outperform. In the classical equation MV=PQ,1 a rise in M has historically been accompanied by a collapse in V, suggesting the economy remained in a liquidity trap. With the fiscal spending spigots now open almost everywhere, a rise in both M and V will be explosive for nominal output. Chart I-3Positive COVID-19 Trends For Europe Chart I-4Money Velocity Outside The US There was significant progress towards a European fiscal union this week, with leaders agreeing to a €750 billion recovery fund. Assuming the agreement is ratified, this will underscore a powerful centripetal force for the common-currency union. As the “anti-dollar,” this is positive for the euro (and negative for the greenback). More on this later. The US economy had been relatively resilient compared to the rest of the world, at least until late. This was in part driven by a late start to state-wide shutdowns. With various US municipalities and states now reversing reopening plans, economic activity abroad is now improving relative to the US. Chart I-5 shows the economic surprise index between the Eurozone and the US is inflecting sharply higher from very depressed levels. Historically, this has usually put a floor under the euro. Similarly, G10 PMIs have bottomed relative to the US. These trends should continue in the months ahead. Chart I-5EUR/USD And Relative Growth How High Can EUR/USD Rise? Agreement on the EU recovery fund was a historic event, not due to the size of the package but because of revealed preferences toward euro membership. For over two decades, the standard dilemma plaguing the euro area was that centralized monetary policy was never a panacea for desynchronized business cycles.2 The lack of fiscal transfers between member nations amplified this problem. With Italian and Spanish bond yields now collapsing towards those in the core, liquidity is flowing to where it is most needed, significantly curtailing euro break-up risk. The key components of the agreement are €360 billion in the form of loans and €390 billion in the form of grants. The money will be borrowed via bonds issued by the European Commission, with maturities of three to 30 years. Repayment will not be due until 2027. The most important component of the deal, the grants, is a de facto fiscal transfer. Going forward, the next catalyst for euro strength must be growth differentials between the euro zone and the US. This will translate into an improvement in the equilibrium rate of interest between the two blocs (Chart I-6). This is quite plausible in a post-COVID-19 world. As a relatively closed economy, the US has tended to have a higher services component to GDP. However, the service sector has been hit much harder by the pandemic due to social distancing measures that will likely remain in place for a while. A more drawn-out services recovery raises the prospect that countries geared more towards manufacturing, such as Europe, Japan and China, could experience better growth (Chart I-7). Chart I-6EUR/USD And The Neutral Rate Chart I-7Service Industries Could Stay Weak For A While Chart I-8The European Periphery Is Competitive Again Internally within the euro zone, a powerful adjustment has already occurred. Unit labor costs in Greece, Ireland, Portugal and Spain are well off their peak. This has effectively eliminated the competitiveness gap with the core that had accumulated over the previous two decades (Chart I-8). Italy remains saddled with a rigid and less-productive workforce, but overall adjustments have still come a long way in plugging a key fissure undermining the common-currency area. The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at very cheap multiples. Part of the reason is that most Eurozone bourses are heavy in cyclical stocks that are well into a 10-year relative bear market.3  A re-rating of cyclical stocks, especially banks and energy, relative to defensives could be the catalyst that carries the next leg of the euro rally. This could push the EUR/USD towards 1.20. As higher-beta, the Scandinavian currencies will also benefit. For now, most analysts remain very pessimistic about European profits relative to those in the US, but that could change if the dollar enters a structural bear market (Chart I-9). Chart I-9Relative Profit Revisions Lead EUR/USD Cyclical Or Structural Move? If the DXY punches through 94, it will likely mark the beginning of a structural bear market.  If the DXY punches through 94, it will likely mark the beginning of a structural bear market. The dollar tends to run in long cycles, driven by fundamentals but also confidence. In our report last week, we suggested three indicators for gauging a shift in confidence. The total return of US bonds versus gold: Gold and US Treasurys are competing assets (Chart I-10), with the dollar being the key arbiter, as we argued last week. The TLT/GLD ratio has dropped from over 1.16 to 0.96, putting it at the precipice of bear-market territory. The USD/CNY exchange rate: Tensions are flaring up between the US and China, with the latest being the US government’s closure of China’s Houston consulate. Yet USD/CNY is still holding around 7. As the key arbiter between the dollar and emerging market currencies, a firm yuan limits upward pressure on the greenback. The gold-to-silver ratio (GSR): This correlates well with the dollar, and has absolutely collapsed (Chart I-11). Given similar moves in gold versus copper and oil, it is fair to assume that the global economy is not in a liquidity trap. Chart I-10Gold And Treasurys Are Competing Assets Chart I-11The Gold-To-Silver Ratio Has Collapsed The more important point is that there is a nascent, concerted push by both institutional investors and central banks to diversify out of dollar assets: The S&P 500 usually moves inversely to gold, but both have been moving in sync since the March lows (Chart I-12). This suggests investors have been using gold rather than US bonds to hedge their equity long positions. The dollar proved to be the best safe-haven asset during the March drawdown. With the Federal Reserve having flooded the system with dollars, gold (and precious metals) are the next logical choice. Since 2014, central banks have been aggressively diversifying out of their dollar holdings. This is not only evident in the official TIC data that continues to show foreign officials are selling Treasurys, but within IMF reserve data well. Part of these flows have gone into other currencies, especially the yen, but a huge portion has been to gold (Chart I-13). This has been driven by emerging market countries such as Russia and China, the same concerns in the middle of geopolitical confrontations with the US. Chart I-12Gold And The S&P 500 Are Moving Together Chart I-13Central Banks Are Loading Their Gold Vaults Within our service (and together with our Commodity & Energy colleagues), we have been highlighting that precious metals will be a huge beneficiary from the Fed’s reflationary efforts, even though they are overbought. As a hedged bet, we have been long silver versus gold, a trade that continues to perform well.   As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers.  Chart 14 shows that precious metals such as silver and platinum are much cheaper from a historical perspective. As the gold trade becomes crowded and demand for diversification from fiat money remains strong, silver and platinum could be the outperformers. Chart I-14Silver And Platinum Remain Relatively Cheap In a nutshell, remain long silver, SEK, NOK and petrocurrencies. Currency traders can also add platinum to the list. These top picks will continue to benefit from global reflation, dollar weakness and a breakout in the euro. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: Existing home sales surged by 20.7% in June compared with May, the highest monthly gain on record. This followed a strong increase in building permits and housing starts last week. The University of Michigan consumer sentiment declined from 78.1 to 73.2 in July, while the Chicago Fed national activity index ticked up from 3.5 to 4.1 in June. Initial jobless claims increased by 1416K for the week ended July 17th, higher than the 1307K increase the previous week. The DXY index continued to edge lower, falling by 1% this week. Our bias is that the US dollar is likely to begin a long depreciation should the global economy continue to rebound.   Report Links: A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020   The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: The current account surplus narrowed from €14.4 billion to €7.95 billion in May. Headline inflation was flat at 0.3% year-on-year in June. Core inflation also remained at 0.8% year-on-year in June. Preliminary consumer confidence marginally fell from -14.7 to -15 in July. The euro appreciated by 1.4% against the US dollar this week, climbing to the highest level in almost two years, alongside European equities. The catalyst was the €750 billion rescue fund (around 5.5% of EU GDP) announced this Tuesday. The fact that member countries reached an agreement is encouraging for the sustainability of the euro.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: The trade deficit narrowed from ¥601 billion to ¥424 billion in June. Exports fell by 26.2% year-on-year while imports fell by 14.4% In June. National headline CPI remained flat at 0.1% year-on-year in June, while core inflation was also unchanged at 0.4%. The Jibun Bank manufacturing PMI increased from 40.1 to 42.6 in July. The Japanese yen rose by 0.2% against the US dollar this week. In the monthly report released this Wednesday, Japan’s Cabinet Office reported improvement in 6 out of 14 economic categories, including consumer spending, exports, production and public investment. However, capital spending, corporate profits and employment remain weak due to the pandemic. That said, we are long the Japanese yen as a  safe-haven hedge.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index rose by 3.7% year-on-year in July, up from 2.1% the previous month. CBI industrial trends survey orders recovered from -58% to -46% in July. The British pound appreciated by 1.6% against the US dollar this week. Near-term volatility around Brexit negotiations is a negative for the pound, but it is cheap and unloved.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Retail sales rose by 2.4% month-on-month in June, following 16.9% increase the previous month. NAB business confidence fell to -15 from -12 in Q2. The Australian dollar jumped by 2.3% against the US dollar this week. The recent RBA meeting minutes suggested that there is no need to adjust its policy measures in the current environment and reiterated that negative interest rates remain “extraordinarily unlikely”.   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data from New Zealand this week: The New Zealand business index surged from 37.5 to 54.1 in June. The New Zealand dollar rose by 1.8% against the US dollar this week. Following weak inflation data last week , the Westpac Economic Bulletin suggests consumer prices will remain subdued on weakened demand. This raises the prospect of further stimulus from the RBNZ.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019   Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: Retail sales increased by 18.7% month-on-month in May. Auto sales were particularly strong. The new house price index increased by 1.3% year-on-year in June.  The Teranet/National Bank house price index rose by 5.9%. Headline inflation increased from -0.4% to 0.7% year-on-year in June, as oil prices recovered. Core inflation also rose from 1.6% to 1.8% year-on-year in June. The Canadian dollar rose by 1.3% against the US dollar this week. The inflation data were stronger than expected, led by gas, food and shelter prices. Going forward, a recovery in energy prices will be important for the performance of the CAD. In general, we like petrocurrencies.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade balance widened marginally from CHF 2.7 billion to CHF 2.8 billion in June. Exports rose by 6.9% month-on-month while imports jumped by 7.3%. Total sight deposits continued to increase from CHF 688.6 billion to CHF 691.5 billion for the week ended July 17th. The Swiss franc appreciated by 1.3% against the US dollar this week. Switzerland has seen a trade recovery in recent months. Notably, luxury goods exports like Swiss watches increased by 58.9% month-on-month in June, though well below pre-COVID-19 levels.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: Exports and imports both improved in June, especially with rebounding oil prices. The trade surplus widened from NOK2.7 billion to NOK3.2 billion. The Norwegian krone appreciated by 1.3% against the US dollar this week. Our Commodity & Energy team holds the view that global fiscal stimulus to combat COVID-19 will support global oil demand. Moreover, both OPEC and the US are likely to continue production cuts. Their bias is that oil prices will continue to grind higher, which is bullish for the Norwegian krone. Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The unemployment rate rose to 9.8% in June, up from 9% the previous month and 7.2% the same month last year. The Swedish krona surged by 2% against the US dollar this week. The latest Labor Force Survey released this week showed that the labor market in Sweden continues to deteriorate. In June, employment fell by 148,000. Average hours worked per week fell by 8.4%. That said, the Swedish krona remains cheap and will benefit from a global economic recovery.   Footnotes 1Where M = money supply, V = velocity of money, P = price level and Q = output. 2Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest", dated June 14, 2019. 3Please see Foreign Exchange Strategy Special Report, "Currencies And The Value-Vs Growth Debate", dated July 10, 2020.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights For financials and energy to produce a sustained rally, there must be no relapse in global growth during the autumn and winter of 2020/21. However, with the coronavirus still in play and the usual flu and virus season yet to come, a key hurdle to overcome will be the physical reopening of schools and childcare facilities this September. Hence, for the time being, remain overweight healthcare and technology versus financials and energy. This implies underweight European stocks versus US stocks, and overweight Germany, France, Netherlands and Switzerland within Europe. Play good news in Europe by remaining long EUR, CHF, and SEK versus USD, and long US T-bonds and Spanish Bonos versus German Bunds and French OATs. Fractal trade: Short silver. Feature Chart Of The WeekDenmark's OMX Is At An All-Time High, While The FTSE 100 Is Languishing. Why? Once upon a time, the stock market existed as a barometer of the economy. Or at least, a good representation of the size and composition of profits in the host economy. But that time is long gone. Today, a tiny handful of companies are driving the performance of supposedly broad indexes such as the FTSE 100 and the S&P 500. Indeed, we should more accurately call the FTSE 100 the FTSE ‘10’ ignoring the other 90. And we should call the S&P 500 the S&P ‘5’ ignoring the other 495. Meaning that stock markets are no longer stock ‘markets’. Yet many analysts still try and explain the stock market’s performance through traditional top-down macro drivers such as GDP growth, profit margins across the host economy, and so on. The trouble is that when the stock market is dominated by a tiny handful of companies, this 20th century approach is doomed to fail. Today, we must take a more granular approach based on the type of companies that are dominating each stock market. Sector Concentration Is Driving Stock Markets The handful of companies that dominate each stock market tend to be the leaders in their global sector. This means that each stock market is defined by a sector concentration, which has often evolved by chance, based on where companies chose to start up and list. This sector concentration usually has little or no connection with the host economy. For example, Denmark’s OMX index is dominated by Novo Nordisk, a global biotech company. The FTSE 100 is heavily weighted to the oil majors Royal Dutch and BP as well as global bank HSBC, which have only a limited exposure to the UK economy. On the other side of the Atlantic, Apple, Microsoft, Amazon, Google and Facebook are massively over-represented in the S&P 500 compared with their contribution to the US economy. A crucial defining feature of a stock market turns out to be its exposure to healthcare and technology – whose profits are in major structural uptrends – versus the exposure to financials and energy – whose profits are in major structural downtrends (Charts 2 - 5). Chart I-2Healthcare Profits Are In A Structural Uptrend Chart I-3Technology Profits Are In A Structural Uptrend Chart I-4Financial Profits Are In A Structural Downtrend Chart I-5Energy Profits Are In A Structural Downtrend The stock market capitalisation in healthcare and technology stands at 52 percent for Denmark and 40 percent for the US, compared with just 20 percent for Europe and 12 percent for the UK. The flip side is that the stock market capitalisation in financials and energy stands at just 8 percent for Denmark and 11 percent for the US, compared with 21 percent for Europe and 30 percent for the UK. This explains, for example, why Denmark’s OMX is hitting all-time highs while the FTSE 100 is languishing (Chart of the Week). That said, the price of the growing stream of healthcare and technology profits can still fall if it is at an unjustifiably high level. And the price of the shrinking stream of financial and energy profits can still rise if it is at an unjustifiably low level. Hence, the key question is: what determines the prices of these two groups of sectors, one whose profits are in a major uptrend, the other whose profits are in a major downtrend? Healthcare And Tech Performance Hinges On The Bond Yield The price of a rapidly growing profit stream is weighted to the values of the large distant cashflows, making it highly sensitive to the discount rate applied to those distant cashflows. Whereas the price of a rapidly shrinking profit stream is weighted to the values of the large immediate cashflows, making it much more sensitive to the near-term evolution of the economy (Box I-1). Box I-1Bond Yield Sensitivity Versus Economic Sensitivity The upshot is that for stocks and sectors whose profits are in a major uptrend, the key driver of the price is the direction of the bond yield. Whereas for stocks and sectors whose profits are in a major downtrend, the key driver is the near-term direction of the world economy (Chart I-6 and Chart I-7). Chart I-6Exposure To Healthcare And Technology Determines Bond Yield Sensitivity Chart I-7Exposure To Financials And Energy Determines Economic Sensitivity Pulling all of this together, the rally in healthcare and technology stocks is extremely vulnerable to a sustained rise in the bond yield. But a sustained rise in the bond yield seems highly unlikely without a breakthrough vaccine or treatment for COVID-19. While the coronavirus is still in play, the long-term hollowing out and scarring in the jobs market will only become apparent in the coming months once furlough schemes and temporary relief programs end. This will force all central banks to remain ultra-dovish and where possible, become more dovish. Meanwhile, for financials and energy to produce a sustained rally, there must be no relapse in global growth during the autumn and winter of 2020/21. However, with the coronavirus still in play and the usual flu and virus season yet to come, a key hurdle to overcome will be the physical reopening of schools and childcare facilities this September. Hence, for the time being, remain overweight healthcare and technology versus financials and energy. This translates to underweight Europe versus the US. And overweight Germany, France, Netherlands and Switzerland within Europe. How To Play Good News In Europe Things have been going right in Europe. First, unlike in the US, the COVID-19 outbreak is subsiding, at least for now. New infections have been steadily declining through the warm summer months (Chart I-8). Chart I-8New Infections Declining In Europe, Rising In The US Second, the ECB has injected ample liquidity into the banking system which, combined with ultra-low interest rates, has permitted a strong expansion in bank lending. Though somewhat disappointingly, the bank lending surveys tell us that the loans are being used for emergency working capital requirements rather than investment. Third, the EU has approved a €750 billion Recovery Fund, over half of which will take the form of grants to the sectors and regions most stricken by the coronavirus crisis. Given that the fund will be financed by jointly issued EU bonds, this amounts to a fiscal transfer to the areas that need the most help. Hence, even if the amount of the stimulus may be smaller than in other parts of the word, it comprises a huge symbolic step towards greater unity in the EU and euro area. Still, despite this trifecta of good news, European stock markets have not outperformed (Chart I-9). This just emphasises that stock market relative performance has little connection with domestic economics and politics. To reiterate, stock market relative performance is almost always the result of the sector concentration of a handful of dominant stocks. Chart I-9Despite Good News In Europe, European Equities Are Not Outperforming Begging the question: how to play the continuation of good news in Europe? The answer is through the currency and fixed income markets, which have a much stronger connection with domestic economics and politics (Chart I-10 and Chart I-11). Chart I-10Play Good News In Europe Via European Currencies... Chart I-11...And Sovereign Yield Spread Tightening Remain long a basket of EUR, CHF, and SEK versus the USD. Our favourite cross out of these three is long CHF/USD given the haven character of the CHF in periods of market stress. To play bond yield convergence between the US and Europe and between core and periphery Europe, remain long US 30-year T-bonds and Spanish 30-year Bonos versus German 30-year bunds and French 30-year OATs.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System* The spectacular rally in silver is fractally fragile, and at a point which has signalled several trend reversals through the past five years. Accordingly, this week’s recommended trade is short silver, with the profit target and symmetrical stop-loss set at 12.5 percent. In other trades, long GBP/RUB achieved its profit target. Against this, short Germany versus UK and long bitcoin cash versus ethereum reached their stop-losses. Long nickel versus copper reached the end of its holding period in partial loss. The rolling 12-month win ratio now stands at 59 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. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations      

The drubbing in the US/EMU sovereign bond spread is cause for concern for the SPX’s slingshot recovery off the March 23 lows, especially given the tight positive correlation of these two series over the past three decades (top panel). Typically, higher relative yields attract capital to US shores and vice versa, and some of that capital inevitably leaks into US stocks. Moreover, theory would suggest that relative yields move with the ebb and flow of relative return on capital. Indeed, the bottom panel of the chart highlights such an empirical relationship. Currently, euro area return on assets is narrowing the gap with the US which usually happens in recessions. The persistent unresponsiveness in the 10-year UST yield near the zero line which stands closer to the ECB’s NIRP, likely spells short-term trouble for the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.