Brasil

Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered.  Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020.  The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed.  Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar.  Therefore, a market reset is also positive for the yen.     Housekeeping Chart I-5Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January.   The DXY index rose by 165 bps this week.  The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3%  quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on  procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion  in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar

Highlights Preserving the fiscal spending rule is becoming economically unviable and politically unfeasible. Breaking the fiscal rule – the most likely scenario in our view – will push up the risk premium on Brazilian markets. Keeping government borrowing costs well below nominal GDP growth is critical to stabilizing the public debt-to-GDP ratio. This cannot be achieved without the central bank’s purchases of government bonds on a large scale. Continue shorting the BRL. A buying opportunity in stocks could emerge after the risk premium rises much more due to the break of the fiscal rule. Feature Chart 1The BRL And Commodities Prices Have Decoupled The Brazilian exchange rate has decoupled from commodities prices (Chart 1). Rising resource prices and the global risk-on environment have failed to produce a meaningful rebound in the real. The reason is that preserving the constitutionally mandated fiscal spending rule is becoming economically unviable and politically unfeasible. Authorities are about to throw in the “fiscal towel”. For some time, Brazil has been staring down two difficult paths: (1) life without fiscal stimulus, or (2) breaking the fiscal spending rule. In the first scenario, the Brazilian government will satisfy the interests of creditors, but inflict material pain on the economy. Yet, the conditions for stabilizing the public debt-to-GDP ratio are still unlikely to be met under this scenario. Without fiscal stimulus, nominal GDP growth will remain below borrowing costs. Besides, government revenue will dwindle, and the fiscal deficit will not narrow substantially. In the second scenario, domestic demand will recover, but the public debt-to-GDP ratio will surge and the outlook on public debt will become extremely troublesome. Therefore, inflating the country out of debt will likely become the sole feasible option in the long run. Below we present the two different policy roads for Brazil, and their effects on the economy, interest rates and financial markets. As we wrote in previous reports and reiterate today, fiscal tightening is not a politically viable scenario for President Bolsonaro. Given economic and political considerations, the president and Congress will likely resort to pump priming to engineer a strong economy before the October 2022 general election. Scenario 1: Life Without Fiscal Support If Bolsonaro and Economy Minister Guedes stick to the original 2021 budget, which allows rising government spending only at a pace of last year’s inflation rate, the economy will experience full-blown debt deflation. The fiscal thrust will be -8% of GDP in 2021, i.e., this amounts to a significant fiscal cliff (Chart 2). Given that the second wave of the pandemic is yet unchecked and the risk of another round of lockdowns continues to rise, the economy cannot handle such substantial fiscal tightening. The inflation rate will decline anew, probably heading towards or below zero (Chart 3). Chart 2Brazil: An Unprecedented Fiscal Cliff Chart 3Brazil: Inflation Remains Too Low Odds are that household, business and government nominal income will shrink (Chart 4). This would entail debt deflation – contracting revenues will severely undermine debtors’ capacity to service their debt.  In addition, real lending rates – which are already elevated – will rise as inflation drops (Chart 5). Chart 4Without Fiscal Stimulus, Nominal Income Will Shrink Again Chart 5Brazil: Real Lending Rates Are High   Chart 6Bank Loans Have Not Recovered Facing a renewed rise in NPLs, banks will curtail lending, thereby depressing final demand (Chart 6).   Rising commodities prices might not be sufficient to reverse such debt deflation in Brazil. The basis is that commodities exports make up 11-12% of GDP. The primary fiscal deficit is projected by the government to narrow from 9% to about 2% of GDP due to the adherence to the fiscal spending rule. In fact, the primary deficit might not narrow as much as the government expects due to the loss of government revenue stemming from very depressed nominal growth. This is very likely in the scenario of fiscal tightening. Market Implications Of Scenario 1: The currency will be initially supported at current levels as the government adheres to fiscal discipline. However, the real will likely depreciate later and act as a release valve as deflation takes a toll on the economy. Chart 7Brazil: A Steep Yield Curve Predicts A Break Of The Fiscal Rule Interest rate expectations will fall and the yield curve will invert, predicting another recession (Chart 7). Share prices of domestic-oriented companies, including small caps, will nose-dive as domestic demand is wrecked. Scenario 2: Breaking The Fiscal Spending Rule This is the most probable scenario of the two. With the pandemic still ravaging the country and no hope of effective and rapid vaccination, the economy cannot recover without additional and meaningful fiscal support.  Chart 8Brazil: COVID-19 Is Coming Back With A Vengeance The second wave of COVID-19 has surpassed the first one in terms of daily cases, hospitalizations, and deaths (Chart 8). Public and private hospitals are on the brink of collapse across the country. State and local governments will probably have no choice but to re-introduce lockdowns. Lockdowns affect low-income households disproportionately, as their jobs are in the service and informal sector, the most vulnerable under quarantine and social distancing rules. Government financial assistance for low-income households is therefore essential. Both Bolsonaro and the political parties holding sway in Congress have an incentive to resort to fiscal stimulus and break the spending rule. The effectiveness of such stimulus in reviving economic activity is the greatest because fiscal transfers to low-income households have the highest multiplier effect. This will also ensure a surge in the popularity of politicians ahead of the 2022 general election. Given Bolsonaro’s rising disapproval rate and the dismal performance of his candidates in last year’s municipal elections, the pressure is increasing to deliver strong economic performance to tout in his presidential campaign next year. Crucially, the strongest objection to breaking the fiscal spending cap has been from Economy Minister Guedes, but there are signs he might be becoming more accommodative. Lately Guedes has stated that he is considering capping health and education expenditures and public sector wages to renew the popular cash handout program, albeit at a smaller amount than in the last two months of 2020. Further, the Ministry of Economy has acknowledged that the second wave of the pandemic has been much tougher than expected, and that a renewal of emergency spending measures would provide a much-needed support to the economy.  However, Bolsonaro has objected to cutting social programs to maintain cash handouts. Chart 9The Brazilian Economy Will Relapse Overall, economic conditions are worsening, making adherence to the fiscal spending rule impossible (Chart 9). Faced between rearranging the budget or providing stimulus and breaking the fiscal cap, Bolsonaro and Congress will likely pursue the latter as reducing expenditures to maintain a smaller version of the cash handout program will not be enough to sustain domestic demand. Can Brazil grow out of its public debt by boosting nominal GDP via fiscal stimulus? We do not think so. Fiscal stimulus alone will be insufficient to inflate its way out of debt. Keeping government borrowing costs well below nominal GDP growth is critical to stabilizing the public debt-to-GDP ratio. This cannot be achieved without the central bank’s purchases of government bonds on a large scale. Fiscal stimulus will lead to another surge in the public debt-to-GDP ratio. Critically, the two conditions for stabilizing the public debt-to-GDP ratio will still be absent. Chart 10Borrowing Costs And Nominal GDP Growth Condition 1: Nominal GDP growth should continuously hover above government borrowing costs: While nominal growth will rise along with fiscal stimulus, so will local bond yields as the central bank lifts its policy rate and the risk premium widens. In short, the breaking of the fiscal rule will push bond yields meaningfully higher and borrowing costs will exceed the reviving nominal GDP growth (Chart 10). When public sector borrowing costs exceed nominal GDP, the public debt-to-GDP ratio will rise as a matter of arithmetic. In turn, the only way to satisfy the first condition is for the central bank and commercial banks to be willing to finance the government on a large scale, i.e., purchase government bonds en masse. This will bring down and cap government local bond yields below nominal GDP growth. Yet, this would amount to public debt monetization and would produce substantial BRL depreciation. For now, the central bank is not considering this option at all. Rather, the monetary policy committee is getting ready to hike interest rates if the fiscal spending rule is broken. Condition 2: The primary fiscal balance should be in substantial surplus. There is no chance that the primary fiscal balance will move into surplus if more fiscal stimulus is enacted (Chart 11, top panel). Notably, in the 2000s the Brazilian government was able to deleverage by running large recurring primary surpluses (Chart 11). In brief, the second condition will be impossible to satisfy with expanding government expenditures. Chart 11Brazil's Debt Dynamics Are Out Of Control Chart 12The BRL Has Room To Sell Off   Market Implications Of Scenario 2 (Our Baseline): The Brazilian real would plunge as the fiscal rule is violated and inflation expectations rise. Crucially, the currency is not cheap according to its real effective exchange rate (REER) (Chart 12). In the near term the US dollar will likely rebound. However, in the medium to long run, the BRL will depreciate more versus other DM currencies than the greenback. We continue to recommend investors short the BRL versus an equal-weighted basket of the euro, JPY and CHF. The central bank will hike policy rates as fiscal consolidation is dodged but it might not be enough to offset the positive push of fiscal stimulus. Consequently, the economy will recover and inflation expectations will rise, as will domestic bond yields. Continue underweighting Brazil within an EM local currency bond portfolio.   Due to public debt unsustainability, we reiterate our underweight in Brazilian sovereign credit within an EM credit portfolio.   In regard to equities, the Bovespa index in US dollar terms has rolled over from its 3-year moving average (Chart 13). This seems to be a technical sign of a major top. Similarly, the small cap stock index in US dollar terms is facing a technical resistance (Chart 14). Investor sentiment will likely go sour as the BCB hikes rates and public debt sustainability is questioned. We recommend investors maintain an underweight stance in Brazilian equities relative to the EM benchmark for now. In the medium and long term, Brazilian share prices could rally on the back of high nominal growth. The investment strategy in this scenario should be going long stocks but shorting the BRL. Stay tuned. Chart 13The Bovespa Is Facing Resistance Chart 14Small Cap Stocks: The Rally Is Due For A Pause   Juan Egaña Research Associate juane@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes  

Highlights Barring dramatic policy actions, the ratio of public debt to GDP in Brazil is set to rise both continuously and significantly.   Authorities can only gratify either the government’s creditors by tightening fiscal policy, or the population by substantially relaxing their fiscal stance. Given that both the president and congressmen face re-election in two years, they will sooner or later choose to please the population at the expense of the creditors. In the near term, authorities might pass a tight 2021 budget to boost investor confidence. However, as the economy crumbles due to the fiscal cliff, President Bolsonaro will likely choose to considerably relax fiscal policy. Provided it is impossible to know when President Bolsonaro will shift his stance on fiscal policy, we are sticking with our structural underweight positions in Brazilian financial markets. Feature The Brazilian government is caught between a rock and a hard place: it must decide either to provide more fiscal stimulus to the struggling economy or to stabilize its mushrooming public debt by winding down fiscal stimulus. If the authorities opt for another round of fiscal stimulus to support domestic demand, they risk losing investor confidence as public debt becomes unsustainable. On the other hand, if the government chooses to aim for fiscal sustainability, they will at the very least need to let current fiscal stimulus programs lapse. This would amount to a fiscal cliff that would devastate the economy. Lingering economic fragility and the lack of a politically feasible and economically justifiable solution will likely lead to political infighting. The latter will damage business and investor confidence. There are already signs that financial markets are becoming uneasy with the sustainability of the nation’s public debt. There are already signs that financial markets are becoming uneasy with the sustainability of the nation’s public debt. Specifically, the term structure of local currency government bond yields has steepened pricing in a higher risk premium (Chart I-1). Neither growth nor inflation outlooks at this point warrant such yield curve steepening. Hence, the latter probably reflects worries about long-term public debt sustainability. Also, the Brazilian real has failed to rally in recent months despite rising commodities prices (Chart I-2).   Chart I-1Brazil: Risk Premium In Local Bonds Has Been Rising Chart I-2Commodities Prices And BRL: A Decoupling?   Faced with the dilemma between public debt sustainability and economic growth, President Bolsonaro will eventually opt for a relaxation of fiscal policy such that government spending limits will no longer be respected. If this happens, his prominent, fiscally conservative Economic Minister, Paulo Guedes will likely resign, and Brazil’s financial markets will plummet. How Large Has The Stimulus Been? Chart I-3Brazil: Fiscal Stimulus Has Been Large To begin, the Brazilian economy has been benefiting from fiscal stimulus (Chart I-3). The COVID-19 fiscal package, excluding credit-type stimulus, is the highest in the region at 8% of GDP. Of that, 67% has already been spent and the rest will be disbursed before year-end. The economy is now facing a non-trivial level of fiscal restraint over the remaining months of this year as fiscal transfers to low-income households have been halved, from 600 to 300 reais per person, and the loan repayment moratorium will expire before October. Concerning the loan moratorium, in March the government implemented a large-scale debt servicing postponement program for consumers and businesses. Altogether, the five largest banks offered a grace period of 2-6 months of principal and interest payments on loans, amounting to 235 billion reais. This is equivalent to 3.3% of GDP. The end of this loan repayment moratorium will likely mark the beginning of a surge in NPLs prompting banks to further tighten credit standards. Notably, new private credit originated by banks has been already shrinking for both households and businesses (Chart I-4). In terms of monetary stimulus, the transmission mechanism of monetary policy in Brazil has been partially broken. Households and companies have not benefitted much from the central bank’s rate cuts. While the SELIC policy rate has reached a historic low of 2%, the prime lending rates remain elevated both in nominal and in real terms (Chart I-5). Chart I-4Private Credit Origination Has Been Contracting Chart I-5Brazil: Lending Rates Are Very High In Nominal And Real Terms   Bottom Line: The economy is recovering from a very low base due to the massive stimulus provided by authorities (Chart I-6). However, provided central government non-interest expenditures are large - they now make up 24% of GDP - curtailment in government spending will have a materially negative impact on the economy. Public Debt Sustainability Brazil’s gross public debt has reached 92% of GDP and is set to move even higher as large fiscal deficits add to public indebtedness (Chart I-7). The social security deficit has also expanded sharply despite last year’s pension reforms (Chart I-7, bottom panel). Indeed, most of those social security savings will only come into effect after the 2022 presidential and congressional elections.  Chart I-6The Economy Is Recovering From A Low Base Chart I-7Brazil: Public Debt And Fiscal Deficits   Public debt-to-GDP ratios only stabilize if (1) governments run large primary fiscal surpluses or (2) nominal GDP growth exceeds government borrowing costs. Neither of these two conditions can easily be met in Brazil. Provided that the primary fiscal deficit presently stands at 7.5% of GDP, drastic budget tightening would be required to push it towards a surplus. Such fiscal tightening would ravage the economy and, hence, is not politically feasible. Notably, Brazil ran large primary fiscal surpluses (about 3.5% of GDP) from 1999 to 2012 which allowed it to stabilize its public debt dynamics. The second stipulation - that nominal GDP growth exceeds government borrowing costs - has not been satisfied since 2013 (Chart I-8). With government bond yields at about 5.5%, nominal GDP growth would need to rise to and remain above 7-8% in order to reduce the public debt-to-GDP ratio. Chart I-8Public Debt Burden Rises When Borrowing Costs Are Above Nominal GDP Growth Chart I-9Brazil: Core Inflation Is Too Low Provided that potential GDP growth in Brazil is probably 2% or lower, nominal GDP growth that is consistently above 7-8% would require inflation to be 5% or higher. Chart I-9 illustrates that core inflation in Brazil is currently only at 1-2%, well below the central bank’s target range. With fiscal policy set to tighten and a partially broken monetary transmission mechanism, it will be impossible for inflation to rise to 5%. Hence, the second stipulation cannot be met in Brazil without drastic policy action being taken. Bottom Line: Barring dramatic policy actions, Brazil will continue experiencing a steep uptrend in its public debt to GDP ratio. What Will Authorities Do? Authorities are likely to pass a tight 2021 budget later this year to boost investor confidence. However, as the economy crumbles again, President Bolsonaro is likely to opt to relax fiscal policy. The government has already submitted to Congress its 2021 budget which entails a substantial fiscal cliff. The government’s non-interest spending is expected to shrink by 23% from estimated 2020 levels, which is equal to 5.7% of GDP. This is what the fiscally conservative Economy Minister Guedes aims to accomplish in his attempt to cap public indebtedness. Guedes hopes that structural reforms will boost the country’s growth potential so that economic activity can do well in face of fiscal tightening. However, there have been little structural reforms in Brazil in the recent years. As a result, it is unrealistic to expect decent economic growth at times of material fiscal tightening. Chart I-10Brazil: Nominal Income Growth Is Very Low On the whole, Brazilian authorities are facing a political economy dilemma. On the one hand, considerable fiscal tightening would gratify creditors but devastate the already weak economy. Specifically, employee income has already slowed to a record low of 4% in nominal terms. Further fiscal tightening would be a political suicide (Chart I-10). On the other hand, failure to dramatically tighten fiscal policy will lead to a revolt in Brazil’s bond and currency markets and will result in higher borrowing costs for both the public and private sectors. President Bolsonaro faces re-election in two years and realizes that he will lose the election if employment and income do not improve substantially. As a result, the odds are high that president Bolsonaro will eventually abandon fiscal austerity. Notably, there are already signs that the president is wavering on the 2021 budget. In particular, he is contradicting himself on the need either for fiscal tightening or the extension of stimulus. Besides, different members of his cabinet have spoken against fiscal consolidation, in general, and against the golden fiscal rule that caps government spending, in particular.  Critically, Bolsonaro’s popularity has risen recently to its highest level since his election because of fiscal transfers to low-income households launched in March. This makes it certain that heading into the elections Bolsonaro will try to attract votes from low-income families by resorting to a fiscal transfer to support their income. This will be a drag on public finances but will boost his re-election chances. Because they are also facing re-election in late 2022, the Congress will likely support the president in his modification of the constitutional fiscal spending rule and his pursuit of a more relaxed fiscal policy, generally, and in his provision of income support for low-income households in particular. However, Economy Minister Guedes will likely resign if his fiscal austerity program is abandoned. The central bank has been clear that it will pursue easy money policies only as long as fiscal consolidation remains on track. If fiscal austerity is thwarted, the central bank might consider raising interest rates. Such action would clash with Bolsonaro’s attempt to engineer a strong economy going into the 2022 elections. It is possible that the central bank president and its leadership will come under fire from the president’s administration and might also quit. Public debt-to-GDP ratios only stabilize if (1) governments run large primary fiscal surpluses or (2) nominal GDP growth exceeds government borrowing costs. Neither of these two conditions can easily be met in Brazil. What will Bolsonaro do when faced with a creditors’ revolt that would raise government bond yields? He might pressure the central bank to launch a quantitative easing program, i.e., the purchasing of government bonds that would bring yields down. This would amount to public debt monetization. Fiscal easing funded by the central bank would boost economic growth, both real and nominal. In such a scenario, it is possible that nominal GDP growth would reach or exceed 7-8% while local currency government bond yields would be capped at 5-6% by the central bank’s purchases. This would entail high inflation, negative real interest rates and signify a central bank that is behind the inflation curve. These conditions would be an ultra-bearish cocktail for the exchange rate. Given 96% of public debt is in local currency, the cost to government finances from currency depreciation will be minimal. Companies and banks, however, have large foreign currency debt exposure and depreciation in the exchange rate will be painful for them. However, this is the least painful way out of the economic deadlock the nation is in. Bottom Line: Brazilian authorities are faced with a political economy dilemma. They can only gratify either the government’s creditors by tightening their fiscal policy, or the population by substantially relaxing their fiscal stance. Given that both the president and congressmen face re-election in two years, they will sooner or later choose to please the population at the expense of the creditors.   Investment Strategies In The Short And Long Term Chart I-11Brazil Versus EM: Domestic Bonds And Sovereign Credit In the short term: So long as the government adheres to fiscal tightening, economic growth will surprise on the downside. The central bank will then reduce the policy rate ever further. In this scenario, local fixed-income and sovereign credit markets could outperform their EM peers (Chart I-11). Equities will struggle as domestic demand disappoints. In the near term, stocks will likely underperform local currency government bonds, so long as fiscal tightening is maintained (Chart I-12). Notably, equities are not cheap – the average of the trailing and forward P/E ratios is close to a record high (Chart I-13). Chart I-12Brazil: Stock-To-Domestic Bond Ratio Is Overbought Chart I-13Brazilian Equities Are Not Cheap   The impact on the currency remains uncertain. It might find support as worries about public debt sustainability are put on hold, commodities prices rise, and the broad trade-weighted US dollar weakens further. However, investors could also look beyond the near term and question the feasibility of such a tight fiscal stance ahead of the 2022 elections. In this context, investors could foresee the government abandoning its fiscal frugality in favor of populist and fiscally expansionist policies. In this case, the currency will struggle. Heading into the elections Bolsonaro will try to attract votes from low-income families by resorting to a fiscal transfer to support their income. In the medium and long term: President Bolsonaro will ultimately opt for considerable fiscal easing, probably next year, in order to bolster economic growth and household income before the 2022 elections. Expansionary fiscal policy will boost growth and benefit the stock market. Yet, it will be very negative for fixed-income markets, sovereign credit and the currency. Local bond yields will rise as investors sell out of bonds. The only way that authorities would be able to cap government domestic bond yields is via quantitative easing, i.e., the central bank’s purchasing of government bonds. This will amount to public debt monetization and will lead to substantial exchange rate depreciation. Chart I-14The Brazilian Real Is Only Modestly Cheap The trade-weighted currency in Brazil is only one standard deviation below its fair value, i.e., it is cheap but not very cheap (Chart I-14). Hence, public debt monetization and higher inflation and lower real rates will cause the exchange rate to plummet.    Local investors should overweight equities versus fixed-income if the fiscal stance is relaxed. International investors, on the other hand, should be cautious as the BRL depreciation will erode their foreign currency return in equities and local currency bonds. Sovereign credit will also perform poorly in this scenario. Bottom Line: Given that it is impossible to know when President Bolsonaro will shift his fiscal policy, we are sticking with our structural underweight positions in Brazilian equities, local currency bonds and sovereign credit, versus their EM counterparts. That said, if the 2021 budget is approved, Brazilian fixed-income markets could outperform their EM peers over the near term. We also continue shorting the real against an equally-weighted basket of the euro, CHF and JPY because the end-game in Brazil will likely be currency depreciation to boost nominal growth.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com   Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations