Developed Countries

Dear client, In lieu of our regular weekly report next week, we will hold a webcast on Thursday at 10:00 am ET discussing both tactical and strategic currency considerations. The format will be a short presentation, followed by a Q&A session. We look forward to engaging with you. Kind regards, Chester Ntonifor Vice President, Foreign Exchange Strategy Highlights Go short the Gold/Silver ratio (GSR). Hold a basket of NOK and SEK against a basket of the dollar and euro. Go long sterling. Feature Chart I-1The Dollar And Business Cycles When constructing a basket of high-conviction positions, the starting point is usually the framework used to build the portfolio. Ours is through a three-factor lens. The first lens determines what macroeconomic environment we are operating in. Think of a four-quadrant matrix, with growth on one axis and inflation on the other. Intuitively, the dollar should do best when global growth is decelerating and inflation is falling. The climatic expression of this is a deflationary bust, when all bets are off and the dollar is king. On the other side of the spectrum, the dollar should weaken as global growth rebounds (Chart I-1). The second lens is valuation. Specifically, as the drop in cyclical currencies in a deflationary bust approach a capitulation phase, value begins to put a cushion under deteriorating fundamentals. In our previous work, we showed that foreign exchange value-trading strategies based on PPP are profitable over the long term.1  Finally, technical indicators are our third lens for two reasons. First, they are the most powerful indicators for short-term trades. Second, they act as a bridge between bombed-out valuations and a subsequent improvement in macro fundamentals. For example, a saucer-shaped bottom in a cyclical currency can usually be a prelude to a U-shaped economic recovery. A high-conviction trade is one that ticks all three boxes or is agnostic to the first but has a powerful signal from both the second and third. Using this framework, we suggest two trades this week. Go Short The Gold/Silver Ratio When looking at our four-quadrant matrix, it is clear that the dollar tends to rise during a downturn, and fall early in the cycle. Intra-cycle performance is more nuanced. With both first- and second-quarter GDP likely to contract severely around the world, growth is likely to bounce back later this year if economies stay open. This should, ceteris paribus, lead to a weaker dollar. A bearish view on the dollar can be expressed by being short the GSR. The Gold/Silver ratio (GSR) tends to track the US dollar (Chart I-2), so a bearish view on the dollar can be expressed by being short the GSR. It is well known that most of the time, bullion is inversely correlated to the US dollar, not only due to the numeraire effect but also as competing monetary standards. Given that silver tends to rise and fall more explosively than the price of gold (Chart I-3), it makes sense that the GSR should inversely track the greenback. Part of the reason for silver’s explosive – albeit lagged – response is that the silver market is thinner and more volatile, with open interest in futures about one-third of gold. Chart I-2GSR And The Dollar Chart I-3Silver Has Explosive Rallies The potency of the GSR is in its leading properties, as it provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. The GSR tends to rally ahead of an economic slowdown, then peaks when growth is still weak but financial conditions are easy enough to short-circuit any liquidity trap. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Not surprisingly, the GSR has led the rise and fall of many ASEAN and Latin American currencies that are at the forefront of manufacturing (Chart I-4). Chart I-4GSR, Latam And Asean Currencies A key assumption in a lower GSR is that the global economy fends off a deeper recession, which would otherwise sustain a high and rising ratio. But even if we are wrong and the dollar remains stronger over the next 12-18 months, the valuation cushion from being short the GSR is outstanding. The ratio broke above major overhead resistance at 100 just as the dollar liquidity crunch was intensifying, and is now staging a V-shaped reversal. Historically, these reversals tend to be quick, powerful, and extremely volatile. Unless gold is entering a new paradigm versus silver, the forces of mean reversion should pull the ratio towards 50 (Chart I-5). Chart I-5Big Downside Potential For GSR The next important technical level for silver is the $18-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, and has provided strong downside support for silver prior to that. If silver is able to punch through this zone, this will help bridge the gap between silver and gold fundamentals. Globally, the world produces 24,201 tons of silver a year and 3,421 tons of gold. That is a supply ratio of 7:1. Meanwhile, the price ratio between gold and silver is 100:1. This seems like a very wide gap, given that the physical supply of silver is in deficit. Bottom Line: We have been flagging the GSR as a key indicator to watch since last year.2 Our sell-stop on the ratio was finally triggered at 100. Place stops at 110, with an initial target of 75. Go Long Sterling, In Addition To NOK And SEK If the dollar is indeed in a renewed downtrend, the most potent beneficiaries of this move will be NOK and SEK. Our basket of long Scandinavian currencies against both the dollar and the euro has a significant margin of safety, even if we are offside on the dollar trend (Chart I-6). The euro will naturally pop on dollar weakness, but a very liquid beneficiary could also be sterling. Trade negotiations between the UK and EU are clearly breaking down. The worst-case scenario is a no-deal Brexit, in which case the pound could significantly decline. The key question would be by how much? Every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20.  The first observation is that each time the odds of a “hard” Brexit have risen significantly, the threshold for cable downside has been 1.20. The first occurrence was the aftermath of the UK referendum in 2016. The second episode was when Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-7). Intuitively, this suggests that every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20. Of course, a pandemic can change this dynamic, as we saw with the drop in cable to 1.15 in March, but this move was not isolated to sterling. Chart I-6SEK And NOK Are Attractive Chart I-7GBP Has Historically Bottomed At 1.2 While a no-deal Brexit is not our base case, it is still instructive to simulate cable downside in the case of  such an event. Given that the last time Britain majorly defected from a union was during the Exchange Rate Mechanism (ERM) crisis in the 1990s, revisiting this episode could be instructive. The episode leading to the collapse of the pound in 1992 has important lessons for today.3 Britain entered the ERM in October of 1990 in an attempt to find a stable nominal anchor. In other words, with high inflation and an overvalued currency, adopting German interest rates was expected to temper inflation and realign the real exchange rate. Fundamental models show the pound as being very cheap. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. As doubts towards the progress of a union began to rise, investors started to question where the shadow exchange rate for ERM currencies lay, especially the Italian lira and the Spanish peseta. Britain also massively stepped up its interventions in the foreign exchange market in August of that year, having to borrow excessively to increase reserves. Britain was eventually forced to suspend its membership in the ERM. Herein lies the key differences with today. Support for the euro within member countries is extremely strong. So, while EUR/GBP may have near-term upside, a destabilizing fall in the pound relative to the euro is unlikely. A substantial rise in the EUR/GBP, assuming little euro breakup risk, is a bet on the fact that not only is the pound misaligned versus the German “Deutschemark,” but it is also expensive versus the Italian “Lira” and Spanish “Peseta.” This seems unrealistic. The pound was overvalued as the UK entered the ERM, judging from its real effective exchange rate adjusted for consumer prices. A persistent inflation differential between the UK and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-8). Moreover, fundamental models show the pound as being very cheap, especially versus the US dollar on both a PPP and productivity basis. During the ERM crisis, most of the adjustment in the pound happened quickly, but a key difference is that it was unanticipated. Foreign exchange markets today are extremely fluid and adjust to expectations quite fast. From its peak, GBP/USD depreciated by 24% by end of October 1992. Peak to trough, cable has fallen by almost 30% today. Given this drop, it is hard to imagine that the probability of a no-deal Brexit is not priced into cable. The real effective exchange rate of the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in magnitude (24% in both episodes). In the event a deal is forged, the pound should converge toward the mid-point of its historical real effective exchange rate range, which will pin it at least 15%-20% higher (Chart I-9). Chart I-8Not Much Misalignment In U.K. Prices Today Chart I-9Cable Valuation Reflects Brexit Risk Bottom Line: Go long the pound as a trade but maintain tight stops at 1.20. Our limit sell on EUR/GBP was a whisker from being triggered this week at 0.9. While we will respect this level, long-term investors can start slowly shorting the cross.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, “Introducing An FX Trading Model,” dated April 24, 2020 avaiable at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report,  “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com. 3 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly negative: Retail sales fell by 16.4% month-on-month in April, following an 8.3% decrease the previous month. The preliminary Markit manufacturing PMI increased from 36.1 to 39.8 in May. The services PMI also improved from 26.7 to 36.9. The NAHB housing market index increased from 30 to 37 in May. This follows a contraction in building permits by 21% month-on-month in April and a 30% month-on-month drop in housing starts. Initial jobless claims kept rising by 2438K for the week ended May 15th. The DXY index fell by 1% this week. The DXY index has been stuck in a narrow trading range between 98.50 and 101, ever since the Fed’s swap liquidity programs were unveiled. This suggests a stalemate between weak global growth and improving financial conditions. Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: GDP contracted by 3.2% year-on-year in Q1. Employment fell by 0.2% quarter-on-quarter in Q1. The seasonally-adjusted trade surplus narrowed to €23.5 billion from €25.6 billion in March. The current account surplus fell from €37.8 billion to €27.4 billion. The ZEW sentiment index improved from 25.2 to 46 in May. The preliminary Markit manufacturing PMI increased from 33.4 to 39.5 in May. The services PMI also ticked up from 12 to 28.7. The euro increased by 1.7% against the US dollar this week. During a recent speech at the Institute for Monetary and Financial Stability Policy Webinar, the ECB member Philip R. Lane reinforced that the ECB will continue to constantly assess the monetary measures and is fully prepared to further adjust its instruments, which might include increasing the size of the PEPP. 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 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: GDP plunged by 3.4% year-on-year in Q1. Industrial production fell by 5.2% year-on-year in March. Machinery orders fell by 0.7% year-on-year in March, following a 2.4% contraction in February. Exports and imports both fell by 21.9% and 7.2% year-on-year respectively in April. The total trade balance fell from a ¥5.4 billion surplus to a ¥930.4 billion deficit. The preliminary manufacturing PMI fell from 41.9 to 38.4 in May. The Japanese yen fell by 0.9% against the US dollar this week. The Bank of Japan announced on Tuesday that it will hold an emergency policy meeting on Friday, May 22nd, following the bleak GDP data on Monday. 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 negative: The unemployment rate slightly decreased from 4% to 3.9% in March. Average earnings including bonuses grew by 2.4% year-on-year. Headline retail price inflation fell from 2.6% year-on-year to 1.5% year-on-year in April. The Markit manufacturing PMI increased from 32.6 to 40.6 in May. The services PMI also improved from 13.4 to 27.8. The British pound increased by 0.9% against the US dollar this week. This week saw the UK selling its long-term government bonds with negative yield for the first time in history. Moreover, the BoE has also not ruled out the possibility of negative interest rates. Please refer to our front section this week for a more detailed analysis on the pound. 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 negative: The Westpac leading index fell by 1.5% month-on-month in April. Retail sales plunged by 17.9% month-on-month in April. The preliminary Commonwealth manufacturing PMI slipped from 44.1 to 42.8 in May, while the services PMI increased from 19.5 to 25.5. The Australian dollar appreciated by 2.6% against the US dollar this week. The RBA minutes released this week noted that the Australian economy had been severely affected by the COVID-19, and most of the contraction was expected to occur in the second quarter of 2020. The current economic contraction is unprecedented in the 60-year history of the Australian economy. 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 Recent data in New Zealand have been negative: The Manufacturing PMI fell from 53.2 to 26.1 in April. The services PMI also plunged from 52 to 25.9. PPI output prices increased by 0.1% quarter-on-quarter in Q1, while input prices depreciated by 0.3% quarter-on-quarter. House sales plunged by 78.5% year-on-year in April. The New Zealand dollar appreciated by 3.4% against the US dollar this week, making it the best performing G10 currency. The RBNZ indicated that the recent rate cuts have not been transferred via lower mortgage rates or lower retail rates. They have also expressed concerns about a higher mortgage default rate once the 6-month mortgage repayment deferrals expire. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Headline consumer prices contracted by 0.2% year-on-year in April, falling into deflationary territory for the first time since 2009. Core inflation fell from 1.6% to 1.2% year-on-year in April. Trade sales contracted by 2.2% month-on-month in March.  Existing home sales plunged by 56.8% month-on-month in April, following a 14.3% decrease in March. The Canadian dollar rose by 1.3% against the US dollar this week. Statistics Canada shows that in April, consumer prices deflation is led by transportation, clothing and footwear, which saw yearly declines of 4.1% and 4.4% respectively. However, consumers paid more for food due to higher demand. Rice, eggs and pork prices rose by 9.2%, 8.8%, and 9% year-on-year respectively in April. In addition, household cleaning products and toilet paper prices also surged in April. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 4% year-on-year in April, following a 2.7% yearly decrease in March. Total sight deposits continued to rise from CHF 669.1 billion to CHF 673.5 billion last week. The Swiss franc appreciated by 0.5% against the US dollar this week. Due to the COVID-19 pandemic, KOF published a new forecast for Switzerland in May, which now forecasts the economy to rebound gradually once the current lockdown restrictions are eased. However, tax revenues in Switzerland are expected to fall by over CHF 5.5 billion this year and CHF 25 billion over the next years. 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 negative: Exports plunged by 24% year-on-year to NOK 58.8 billion in April. Imports fell by 10.8% year-on-year to NOK 55.5 billion. The trade surplus fell by 78.5% year-on-year to NOK 3.2 billion. The Norwegian krone appreciated by 3.2% against the US dollar this week, fuelled by the recent oil prices recovery. Statistics Norway showed that the recent plunge in exports was mostly led by crude oil, natural gas, and fish exports. Natural gas condensates exports, on the other hand, rose by 44.7% year-on-year in April. That being said, we remain long the Norwegian krone from the valuation perspective. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industry capacity fell slightly from 89.4% to 89.2% in Q1. Total number of employees grew by 0.3% year-on-year in Q1, compared with a 0.4% growth the previous quarter. The Swedish krona appreciated by 2.8% against the US dollar this week. In the latest Financial Stability Report released this Wednesday, the Riksbank highlighted that “if the crisis becomes prolonged, the risks to financial stability will increase”. Moreover, the Bank stated that they are ready to contribute by providing the necessary liquidity to help banks maintaining sufficient credit supply. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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Highlights China faces unprecedented socioeconomic challenges but its political response is rigid rather than flexible. The twin political goals of centralization and self-sufficiency bode ill for productivity. Communist Party elites have become more ideological and provincial, less cosmopolitan and technocratic. A global protectionist backlash adds to China’s woes. Over the long run, favor cyclical and commodity plays that benefit from China’s reflation but are distanced from its large and persistent political and geopolitical risks. Feature In ancient times Chinese emperors ruled with the “mandate of heaven.” As long as they could keep famine, rebellion, invasion, and plague from ravaging the nation, they were perceived as having divine sanction. Their dynasty would retain power and the people would be kept in awe (Table 1). Table 1Disease And The Fall Of Chinese Dynasties The COVID-19 pandemic and recession are highly unlikely to cause the downfall of General Secretary Xi Jinping and the Communist Party “dynasty.” But it is part of a string of recent challenges to the regime that are secular and structural in nature. The regime’s response, thus far, has been rigidity rather than flexibility – a warning sign that things may get worse before they get better. Investors should not view China as “fundamentally stable,” as has largely been the case for the past 20-30 years. Instead they should view it as fundamentally unstable and therefore a source of understated risk to the Chinese currency, equities, and corporate bonds. This is especially true relative to markets that benefit from Chinese reflation yet are distanced from its political and geopolitical risks. Political risks are more likely to manifest in China’s periphery in the short run. Mainland Chinese political risks are more likely to manifest over the long run. A Massive Reflationary Kick China convenes the National People’s Congress on May 21, after a two-month delay due to the extraordinary COVID-19 pandemic. The annual legislative session typically drives reflationary sentiment in the global economy and financial markets, especially in years of crisis such as 2009 and 2016. This year should be another such year, particularly viewed from a long-term perspective. Investors can count on massive Chinese stimulus because the spike in unemployment poses a threat to social stability. Chinese authorities are wheeling out the big guns for this crisis. The fiscal measures announced thus far should reach 10% of gross domestic product. The “quasi-fiscal” function of Chinese banks could push the total well above that when all is said and done. Investors can count on massive stimulus because the spike in unemployment poses a threat to social stability. The economy is contracting for the first time since the Cultural Revolution (Chart 1). Chart 1China's Rapid Growth, A Pillar Of Stability, Is Officially Gone Table 2The Great Chinese Boom, 1980-2020 Ever since that chaotic period, the Communist Party has based its legitimacy on economic growth and rising incomes. The results of China’s economic boom of 1980-2020 are well known. China’s share of global GDP has risen from 2% to 16%; its share of global capital stock from 3% to 21%; exports 1% to 13%; and military spending 1% to 14% (Table 2). In the future, with this economic pillar cracked, Beijing will have to devote even more attention to “stability maintenance” at home. Reflation Doesn’t Solve Structural Problems Household consumption is China’s only hope for developing sustainable economic growth in the wake of a boom driven by investment in export-manufacturing and construction. Cyclically, the virus threatens consumption by discouraging consumers from going anywhere other than work. However, China’s suppression of the virus is enabling consumers to resume activity gradually. Elsewhere, including Europe, economic expectations are also perking up, corroborating China’s data that consumers are increasingly willing to venture out of their homes (Chart 2). Still, China is vulnerable to subsequent outbreaks and is already instituting new lockdowns in the northeast. Structurally, China’s economy is susceptible to a series of historic shifts that were already taking place and that the pandemic has accelerated. The working-age share of the population is now declining rapidly. This coincides with a drop in the national savings rate (Chart 3) and a rapid rise in the dependency ratio – faster even than in Germany or Japan over the past two decades. Consumption will rise relative to investment. But if households are precautionary savers, as in Japan, then consumption will not grow fast enough to sustain overall GDP growth, forcing the government to spend more to shore up overall demand. Chart 2Chinese And Global Sentiment Recovering Chart 3China's Demographic Changes Portend Higher Cost Of Capital China no longer primarily channels its savings into export manufacturing. Instead it invests them at home. China’s total debt – public and private – has surpassed that of many developed nations despite the country’s lower level of development and wealth (Chart 4). China can manage this debt, given that it prints its own currency, keeps a closed capital account, and has shifted to a primarily domestic-oriented economy. But the debt is less manageable than before the crisis. Nominal growth has fallen beneath interest rates, implying that, in the midst of the crisis, debt cannot be serviced for the economy as a whole (Chart 5). Growth will revive, but it will likely run at lower rates than prior to the crisis. Debt servicing will be a recurrent problem for small or inefficient businesses. Chart 4China’s Indebtedness Will Continue To Surge Chart 5China Needs Growth To Service Debt Chart 6China Struggling To Avoid 'Twin Deficits' The whole problem is illustrated by China’s verging on “twin deficits” – an ever-widening budget deficit combined with a recent tendency to slip into current account deficit (Chart 6). Anglo-Saxon economies often run large twin deficits. But China is more comparable to Japan, which has never let itself run persistent current account deficits, since it would then become reliant on foreign sources of financing. Since China will run large budget deficits for the foreseeable future, it will either have to make its corporate sector more efficient (e.g. by depressing wages), or it will see downward pressure on the currency as a result of a weakening current account balance. The pandemic and recession will pass, thanks to massive stimulus. What will remain is China’s voyage into new territory. Prior to COVID-19 the concern was that China would grow old before it grows rich – that the transition to a low-growth consumer economy would occur at a much lower level of GDP per capita than it did with economies like Taiwan, Japan, and South Korea. Now, with a sudden downward shift in growth rates, it is possible that China will grow old without growing rich. This would be a huge risk to the regime in the long run. The Communist Party Returns To Its Roots Risk of economic stagnation – the so-called middle-income trap – is why policymakers at the National People’s Congress this weekend will lay so much emphasis on “reform and opening up,” even as they are forced by the pandemic to do the opposite for now and stimulate the economy via debt-financed fixed investment. China has pledged sweeping structural reforms, liberalization, and internationalization so many times now that it is common for western policymakers to complain of “promise fatigue.” The lack of verification is one reason foreign governments are increasingly willing to consider punitive measures in dealing with China. Today’s macro and geopolitical context do not favor liberal reforms, such as occurred in China in the late 1990s, but the changing characteristics of China’s elite political leaders reveal a more specific reason why policy has grown more statist, more “communist,” and less liberal, over the past decade. Members of the Politburo Standing Committee (PSC), the most powerful decision-making body, have become more ideological, more authoritarian, less cosmopolitan, and less technocratic over the years (Chart 7). They are far less likely to have studied the hard sciences or engineering than their predecessors, who orchestrated China’s westernizing, capitalist reforms from the 1980s to early 2000s. Chart 7China’s Leadership Increasingly Provincial And Inward-Looking They lack experience running state-owned enterprises, which might seem like a plus, except that the alternative is being a career politician – a ruler of a province – and never having run any business at all. Leaders increasingly hail from rural provinces, as opposed to the wealthy, internationally savvy coasts. Chart 8China Will Miss Some Centennial Income Targets Essentially, the grassroots interior of the country – the base of the Communist Party – has been reclaiming the party from the corrupt, liberal, westernizing technocrats. And the party is about to grow even more reactionary. First, it is now officially failing to meet its own development goals. For several years the administration has talked of abandoning annual GDP growth targets as part of its push to prioritize quality rather than quantity of economic growth, but has not done so. Now it is not only the annual growth target that will be missed in 2020, but the party’s decade goals will have to be fudged (Chart 8). Moreover, if the economy does not recover as quickly as hoped then the highly symbolic 2021 centennial of the Communist Party will be marred. Replacing hard numerical targets is reasonable but will not change the party’s constant need to emphasize development goals to keep the people looking forward. And it will not remove the local-level incentive structures that cause economic distortions to meet central government goals. The takeaway is that massive stimulus is assured as the party cannot afford to suffer instability over this period of political milestones. Second, the administration’s difficulties open up at least some possibility of factional struggle within the party. Remember that Xi Jinping was supposed to step down in 2022 at the twentieth National Party Congress. This would have marked the end of his ten-year rule according to the rules that his two predecessors tried to establish. Xi altered this pattern in 2017 to pave the way to rule until 2035 or beyond. Thus while the market can look forward to stimulus this year and next to ensure the economy has stabilized by 2022 (Chart 9), there is potential for surprising political events to rattle China’s appearance of political stability and unity. Chart 9Xi Jinping Was Originally Slated To Step Down In 2022 Granted, Xi has shifted the party’s governance model from single-party rule to single-person rule. The most likely political shocks will come from Xi cracking down on his opponents to re-consolidate power, as he did in 2012-13 and 2017. Factional struggles could cause minor risk-off episodes in financial markets but they will say something more important, which is that the unity of the ruling party is a façade and stability cannot be assumed forever. Economic Targets: Centralization And Autarky In the coming years, Xi Jinping’s government will continue to centralize control over society and the economy as it has done throughout his term. This is the opposite of “reform” in the sense of former leader Deng Xiaoping, which meant decentralizing power and letting local governments and private business innovate. The Xi administration’s “reform” push was to cut industrial overcapacity and deleverage the corporate sector, as we highlighted in a series of reports from 2016-18. We argued then that these reforms would be abandoned as soon as major downside risks to growth returned – which is what occurred due to the trade war and now COVID-19. Thus the net effect of the Xi administration thus far has been to centralize the economy and pursue self-sufficiency. Centralization can be shown in the resurgence of the Communist Party, the central government in Beijing, and state-owned enterprises. Government debt has grown at the expense of private leverage (Chart 10), which faced a crackdown, while the state-owned share of corporate debt has grown from one-half to two-thirds since 2013. Xi formally pledged in 2017 to make state companies stronger, better, and bigger. His term has witnessed a major bull market in SOE equities relative to the broad market – and each phase of power consolidation adds a new rally to this trend (Chart 11). Chart 10Public Sector Encroaching On Private Sector … Before COVID-19 Chart 11SOE Bull Market Under Xi Jinping As for international trade, China has become far less reliant on foreign parts and components for its manufacturing sector over recent decades (Chart 12). It has also increasingly used state resources to pursue strategic self-sufficiency through technological acquisition, import substitution, and state-backed “indigenous innovation.” The attempt to make a new Great Leap Forward in advanced manufacturing and high-tech services has led to a direct clash with the US government, which is now actively expanding export controls. In the upcoming fourteenth Five Year Plan for the years 2021-25, Beijing is highly likely to double down on technological self-reliance. Chart 12China Closes Its Doors Chart 13Centralization And Closed Economy Harm Productivity Centralization and import substitution have harmed productivity, especially total factor productivity (Chart 13). Centralization is not necessarily bad for productivity – state-directed research and development can galvanize major improvements. But in China centralization is excessive and constricts the flow of information and ideas in civil society and academia, which discourages innovation and privileges quantity over quality of output. Closure to the outside world reinforces this point – particularly as a global protectionist backlash comes to affect China’s acquisition of tech and talent – and exacerbates the misallocation of capital at home. Social Unrest Will Grow China’s falling potential growth will generate social unrest over time, despite the appearance of perfect control in this authoritarian society. Table 3 shows our COVID-19 Social Unrest Index. Countries are ranked from best to worst, top to bottom. Obviously a high rank does not suggest a country is immune to unrest – all emerging markets are vulnerable. A poor score under “household grievances” – i.e., income inequality combined with the “misery index” of high inflation and unemployment – can engender unrest even in relatively well-governed states, as is happening in Chile. Table 3China Looks Stable On Paper: Our COVID-19 Social Unrest Index China ranks fourth overall, with poor governance indicators dragging down the total. However, household grievances will rise as the unemployment rate rises (and perhaps food and fuel inflation). Unemployment is much higher in China than officially reported. The government is also unfamiliar with how to deal with large surges in unemployment, having long utilized policy to minimize the unemployment rate at any cost (Chart 14). Chart 14AUnemployment Spike A Threat To Chinese Stability Chart 14BUnemployment Spike A Threat To Chinese Stability Chart 15Income Inequality In China Inequality is at extreme levels and will worsen as a result of COVID-19. Our China Investment Strategist shows that the bifurcation in wealth between the top 10% and the bottom 50% will widen as job losses hit low-skilled and labor-intensive sectors (Chart 15). The rural-urban disparity – an obsession of policymakers in recent years – will also grow amid the crisis (Chart 16). Two factors are aggravating these trends. First, the decline of the manufacturing sector alluded to above. China’s manufacturing sector was too large and it has been rapidly converging to the level of developed economies, meaning that as many as 10% of workers’ jobs are at risk in the coming years. A maturing economy and mercantilist geopolitical trends are accelerating this process (Chart 17). Beijing will have to confiscate wealth from the coastal provinces and power centers to reduce inequality and social grievances. Chart 16Regional Inequality In China Chart 17Large Manufacturing Sector Getting Purged Second, migrant workers are drifting home amid the COVID-19 crisis, just as in 2008. 51 million migrants vanished from employment rolls in the first quarter (Chart 18). The government’s model of household registration reform has focused not on making it easier for migrants to integrate into wealthy coastal provinces but rather on subsidizing activity in interior provinces and foisting workers back into their home provinces. This is a trigger of unrest. Will social unrest end up being politically significant? In most cases no. Beijing is prepared to quell protests and dissent – it has devoted massive resources to domestic security, even compared to its rapid military modernization (Chart 19). Chart 18Migrant Workers Cast Adrift Amid COVID-19 Chart 19‘Stability Maintenance’ Is A State Priority The Communist Party began prioritizing “social stability maintenance” across all dimensions of society in the wake of the global financial crisis in 2008. The abortive “Jasmine Revolution” in 2011, at the height of the Arab Spring, was literally swept away by street-cleaning trucks. The Wukan riots that same year were more persistent, flaring up again in 2016, but the siege was ultimately confined to a single city in the generally more restive south. Various shows of defiance in Wuhan and Hubei in the wake of COVID-19 have been snuffed out. Social unrest will not always be politically significant. State repression and mismanagement could turn any minor incident of unrest into a major incident. But as long as disturbances remain local, they will have limited political consequences. The risk for China is its pursuit of innovation and technological modernization. Greater connectivity will increase the potential for cross-border coordination. The running assumption is that China is an authoritarian state with sufficient police force to silence any discontent. But political activism does not have to be liberal – it could be nationalist, or simply based on quality of life issues that cannot easily be demonized. At any rate, the dislocation of the manufacturing sector and labor market in the context of a secular growth slowdown is a long-term tailwind for social and political challenges to the state. Political risk will grow, not fall, from here. Diversions From Domestic Unrest Beijing’s attempt to re-centralize power and reassert Communist Party control has sparked resistance in the Chinese periphery. Both Taiwan and Hong Kong have seen protest movements – consisting of middle class workers as well as youth – since 2013. These movements have not spread to the mainland – if anything they are a diversion from the mainland’s own problems. But they have prompted Beijing to crack down on the periphery, further polarizing opinion. While unrest in Hong Kong will heat up as Beijing attempts to impose even more direct control, ultimately Hong Kong has no alternative. Taiwan, on the other hand, is an island that already largely conceives of itself as an autonomous unit. The sense of Taiwanese identity – as opposed to Chinese – has exploded upward in recent years (Chart 20). There is a very high bar for war in the Taiwan Strait. And yet Chinese military hawks and strategists have begun to discuss it more openly. China’s military drills around the island are a measured but intimidating response to the rise of the popular, nominally pro-independence government since 2016. The US is making active but measured moves to shore up the diplomatic and military relationship with Taiwan. Given Washington’s renewed focus on China’s drive to achieve dominance in semiconductors, and America’s desire to secure supply chains that run through Taiwan and the mainland, we remain fully committed to our view that Taiwan is a major underrated geopolitical risk. Given the high bar for outright war on Taiwan, it should be no surprise that disputes over sovereignty and military positioning in the South China Sea should revive (Chart 21). This is a convenient outlet for Chinese nationalism. The sea is of vital strategic importance to all the major East Asian economies – not because of resources but because of supply security. Military actions in the sea have a direct bearing on cross-strait relations as well as Sino-Japanese relations, which are also liable to flare up during periods of economic distress. Chart 20Tensions In Chinese Periphery Set To Increase Chart 21South China Sea: Not Just A Distraction The US is pushing back in the seas as well, increasing the odds of a skirmish or incident. Recent reports that China will seek to establish an air defense identification zone (ADIZ) in the South China Sea have been dismissed by Taiwanese authorities, but an ADIZ is just one of many plausible scenarios that could escalate tensions overnight. Will The US Sabotage China? The US election has the potential to exacerbate China’s economic and political insecurities in the near term. The major constraint on US-China economic decoupling is well known: US allies, such as Europe and Japan, can and will continue to trade with China. Thus the US would suffer the most if it insisted on an outright blockade of trade or tech. The implication, however, is that President Trump will change strategy in any second term. There is a substantial risk to European industry that he could attempt a trade war with the EU as well as China. But the major constraint – that the US cannot take on China alone – means that his advisers across all parties and agencies will urge him to change his position. Whether he will listen is anybody’s guess. Meanwhile a Democratic victory will ensure a multilateral strategy is adopted, as was the case from 2008-16. The real political risk comes when Xi Jinping attempts to step down and pass the baton to a successor. In this regard it is essential to recognize that China’s progress up the manufacturing value chain is a threat to US allies independently of the United States (Chart 22). Chart 22China’s Manufacturing Rivals Advanced Nations Judging by China’s fastest growing export categories, Germany, South Korea, Taiwan, Japan, and Singapore have nearly as much to lose as the United States if China’s state-backed trade practices are not constrained (Chart 23). These include illegal tech transfer, hacking, and increasingly Russian-style disinformation campaigns. Chart 23US Not Alone In Concern Over China’s Manufacturing Machine Chart 24China's Rise Comes At Expense Of US Allies, Not Necessarily US In terms of overall geopolitical power, China’s rise has occurred at the expense of Japan and the EU as well as the United States, even though Europe is less threatened militarily (Chart 24). The implication is that if the US should make a concerted diplomatic effort to form a united front against China demanding verifiable reform and opening, it will eventually be able to bring its allies over to the cause. Xi Jinping’s Succession Crisis How would China respond to this external pressure, which threatens to pile onto its new domestic woes? China will resist US unilateral pressure tactics, so confrontation with a re-elected Trump could be very destabilizing. A “grand alliance” of the West that leaves open the path to economic cooperation could force China to capitulate and offer real concessions. But we are far from there today. Faced with outright confrontation or multilateral encirclement, China will double down on self-sufficiency. Thus geopolitics reinforces China’s internal political evolution and the macro backdrop outlined above. Centralization, Maoism, protectionism, and confrontation with the United States suggest that China faces serious trouble over the long run, especially when today’s massive stimulus wears off. Chart 25Markets Want Chinese Reforms And A Trade Deal Will the challenges be so great as to deprive Xi Jinping of the mandate of heaven? Not anytime soon. He sits at the helm of a wealthy authoritarian state and has the distinct advantage of having consolidated power, from 2012-17, prior to the onslaught of internal and external pressure. He enjoys popular support, despite the seeds of unrest identified in this report. The real political risk for the Communist Party comes when Xi Jinping attempts to step down and pass the baton to a successor. It was the succession after Chairman Mao Zedong’s death that occasioned the power struggles of the late 1970s. And it was Deng Xiaoping’s various attempts to set up a successor that led to unrest and party divisions in the 1980s, culminating at Tiananmen Square. The implication is that systemic regime instability is a long way off – yet still discernible. Chinese equities trade at a high risk premium. However, it may persist for some time. Political and geopolitical trends are not positive for China’s growth, productivity, private sector, or trade over the long run. Equity returns in USD terms over the course of the just-finished bull market compare very unfavorably to the previous bull market (Chart 25). On a 12-month and beyond investment horizon, we recommend investors seek cyclical and commodity plays that benefit from Chinese reflation yet are removed from its governance and geopolitical risks. These include industrial metals, Southeast Asian assets, and Japanese and European equities.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Highlights Higher OPEC 2.0 production in 2H20 – likely beginning in 3Q20 – will be required to keep Brent prices below $50/bbl going into the US presidential elections, which arguably is the primary driver of prices in the 2020 post-COVID-19 recovery. Larger-than-expected OPEC 2.0 production cuts announced this month will force deeper inventory draws beginning in 3Q20. The re-opening of global economies and promising vaccine developments notwithstanding, we continue to expect an 8mm b/d hit to oil consumption this year, followed by an 8mm b/d recovery in demand next year. Brent prices likely will trade slightly higher than we forecast last month – $40/bbl this year, on average, vs. a $39/bbl forecast last month, and $68/bbl next year, $3/bbl above April’s forecast.  We expect WTI to trade $2 - $4/bbl below Brent (Chart of the Week). Two-way price risk is high: The likelihood demand will surprise to the upside cannot be ignored, but it could collapse with a second COVID-19 wave forcing lockdowns again.  On the supply side, the hurricane season is off to an early start in the US, with the first tropical storm, Arthur, named this week. Feature Chart of the WeekOil-Price Recovery In 2H20, 2021 Chart 2OPEC 2.0 Delivers Massive Production Cuts Political considerations – i.e., keeping crude oil prices below $50/bbl so as not to spike gasoline prices going into the US presidential elections – will drive the evolution of crude oil prices. The big driver of oil prices over the short term is what we know with the least uncertainty. Right now, that’s what's happening on the supply side over the next couple of months. Slightly further out – as November approaches, to be precise – the political economy of oil once again will dominate fundamentals. Political considerations – i.e., keeping crude oil prices below $50/bbl so as not to spike gasoline prices going into the US presidential elections – will drive the evolution of crude oil prices. That is why, we believe, the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies earlier this month – amounting to ~ 1.2mm b/d of cuts in addition to those agreed by OPEC 2.0 in April – are so important: The global inventory overhang produced by the COVID-19 pandemic, and the short-lived market-share war launched by Russia in March, has to be unwound as quickly as possible, before the US presidential elections kick into high gear. Holding to the schedule agreed in April would drain inventories, but not fast enough by September to prevent further distress for OPEC 2.0 member states as the year winds down.1 By then, additional cuts would be highly problematic, given US President Donald Trump almost surely will be demanding higher OPEC production to keep gasoline prices down as voters go to the polls in November. KSA announced plans to reduce production by ~ 4.5mm b/d vs. its April level of 12mm b/d starting in June, taking its output to ~ 7.5mm b/d. This cut is 1mm b/d more than what it agreed to last month to balance the oil market. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. Production cuts by OPEC 2.0 as a whole – led by KSA and Russia – begun in May and extending at least to the end of June will amount to ~ 9mm b/d, or close to 9% of global production (Chart 2). Chart 3US Shale-Oil Output Cuts... Outside of the OPEC 2.0 production cuts, we expect US shale-oil output to fall sharply – down ~ 2mm b/d this year from its peak in December, 2019 (Chart 3). The shale-oil supply destruction will lead total US production down by 600k b/d y/y in 2020 (Chart 4). US production losses will account for the largest share of non-OPEC production losses globally. Along with losses from Canada, Brazil and Norway in the wake of the COVID-19 demand destruction, we expect global oil production to fall 12mm b/d y/y by the end of June. Chart 4... Lead US Production Sharply Lower Demand Could Come Back Stronger For the year as a whole, we are leaving our expected demand loss at 8mm b/d, with most of that loss occurring in 1H20. That said, demand could revive sooner than expected, if the anecdotal reports of stronger-than-expected recovery in China prove out – the level of demand there is believed to be close to 13mm b/d in May, after falling to ~ 11.25mm b/d in February and March.2 Kayrros, the oil-inventory tracking service, noted its satellite imagery indicates, “Oil demand losses appear far lower than the prevailing view in April. Measured crude oil builds are wholly inconsistent with prevailing views of a collapse in oil demand of nearly Biblical proportions.” Furthermore, “By early May, there were clear signs of robust recovery in Asian crude demand as well as earlier-stage recovery in US end-user product demand. In addition, steep, swift supply cuts helped rebalance the market, leading to surprisingly deep inventory draws. But demand had never plunged as low as widely believed in the first place.”3 Our estimate of oil-demand destruction is less than that of the major data-reporting agencies. If this performance is repeated globally in EM economies – the historical growth engine of commodity demand – markets could tighten faster than we expect (Chart 5). Our estimate of oil-demand destruction is less than that of the major data-reporting agencies. In their May updates, EIA expects 2020 demand to fall 8.1mm b/d y/y in 2020, vs. 5.2mm b/d last month; OPEC sees demand falling 9.1mm b/d y/y, vs. 6.9mm b/d last month; and the IEA has it at 8.6mm b/d y/y, vs. 9.3mm b/d last month. Chart 5EM Demand Could Revive Quickly Chart 6Massive Fiscal and Monetary Stimulus Will Boost Aggregate Demand Globally By next year, we expect global demand will rise 8mm b/d y/y, driven by the massive monetary and fiscal stimulus that will continue to boost aggregate demand higher (Chart 6). In 2H20, we see demand recovering as flowing supplies fall (Chart 7), forcing onshore inventories to draw sharply in 2H20 and into 2021 (Chart 8), as well as floating storage (Chart 9). In addition, This will flatten the forward Brent and WTI curves in 2H20, and backwardate them next year, as storage draws continue (Chart 10). Chart 7Oil Supply Falls, Demand Rises ... Chart 8... Onshore Inventories Draw More Than Expected Chart 9Expect Floating Storage To Empty Rapidly Chart 10Falling Storage Levels Will Push Forward Curves Into Backwardation Political Economy Drives Price Evolution The risk of higher gasoline prices as crude marches higher this summer is a risk President Trump already has shown he will not countenance. Following the massive production cuts being implemented this month and next by OPEC 2.0 and the large involuntary output losses outside the coalition, there is a risk prices could rise rapidly in 2H20. The fairly high likelihood demand surprises to the upside in 2H20 cannot be ignored, which would further fuel a price spike. This is a combustible political mix. The risk of higher gasoline prices as crude marches higher this summer is a risk President Trump already has shown he will not countenance, particularly not as an election looms. With this in mind, we iterated on the production required to keep Brent prices below $50/bbl in 2020 in our modeling, consistent with our view of the political economy considerations US elections impose (Table 1). Any additional volumes needed to keep Brent below $50/bbl can be returned to market fairly quickly out of OPEC 2.0 spare capacity. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) OPEC 2.0’s production cuts have sharply increased the group’s spare capacity to ~ 6.5mm b/d – 5.5mm b/d in OPEC and close to 1mm b/d in Russia and its allies – which means these states will be capable of modulating production quickly and with fairly high precision. The Return Of OPEC 2.0 Production Discipline The budgets of the OPEC 2.0 states have endured massive hits, which can only be repaired by higher oil-export revenues, given their dependence oil sales. After the US elections, OPEC 2.0 production discipline will have to be revived, given the massive fiscal constraints these states are facing. The budgets of the OPEC 2.0 states have endured massive hits, which can only be repaired by higher oil-export revenues, given their dependence oil sales. KSA will want to manage the rate at which prices increase, so that prices rise while global markets are awash in fiscal and monetary stimulus. We believe Russia will acquiesce on this point – i.e., it will not reprise its role as a price dove arguing for lower prices against KSA’s desire for higher prices – given the damage done to its economy from the price collapse in 1H20. That said, taking inventories from historically high levels back down to their 2010-14 average levels – the storage target pursued by OPEC 2.0 prior to the COVID-19-induced price collapse – likely will keep price volatility elevated (Chart 11). An upside demand surprise while production is being aggressively curtailed could sharply raise prices. Indeed, in our modeling of 2021 prices, we again iterated on production to keep Brent prices below $80/bbl, which we believe is the level both KSA and Russia can agree on for the short term. We also believe that the massive fiscal and monetary stimulus sloshing through EM and DM economies will make such prices bearable, provided they are not the result of a supply-side shock. Chart 11Oil Price Volatility Will Remain Elevated The level of uncertainty in the oil markets remains extraordinarily high. Bottom Line: Our price forecasts are premised on a resumption in global growth in 2H20 that lifts crude oil demand, and sharper-than-expected voluntary and involuntary production cuts taking supply significantly lower over the balance of the year and into next year. As the volatility chart above shows, however, the level of uncertainty in the oil markets remains extraordinarily high: A demand surprise to the upside cannot be ignored, but it also could collapse again with a second COVID-19 wave forcing another round of lockdowns. On the supply side, Tropical Storm Arthur launched the hurricane season weeks ahead of schedule. This elevates supply risk in the US Gulf until the end of November, when the season ends. We expect 2020 Brent prices to average $40/bbl and 2021 prices to average $68/bbl. WTI will trade $2-$4/bbl lower. Two-way risk – upside and downside – abounds.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight OPEC's May Monthly Oil Market Report noted Iraq failed to raise crude oil output in April amid the market-share war instigated by Russia’s refusal to back additional production cuts at OPEC 2.0’s March meeting. Saudi Arabia, Kuwait, and UAE managed to move their production up by 2.2mm b/d, 2.2mm b/d, and 330k, respectively. In our global oil balances, we assume Iraq will increase production along with core-OPEC 2.0 countries to balance oil markets once demand rebounds later this year. However, its declining production last month could signal Iraq’s ability to increase production is limited and that it will struggle to meet its increasing quota in 4Q20 and 2021. Base Metals: Neutral China’s policy-driven economic recovery continues. Last week’s data release provided evidence of a rebound in the manufacturing, infrastructure, and construction sectors (Chart 12). This will continue to support base metals – primarily copper and aluminum. Precious Metals: Neutral Chairman Powell’s comment that there is “no limit” to what the Fed can do with its emergency lending facilities supports our view that US real rates will remain depressed as inflation expectations move up ahead of nominal rates. Gold and silver are up 2% and 14% since last Tuesday. We believe silver slightly below its equilibrium price vs. gold and industrial metals (Chart 13). Silver could continue to temporarily outpace gold as it moves to equilibrium. Ags/Softs:  Underweight US corn planting for the 2020/2021 season is approaching the finish line, with 80% of the crop in the ground so far, as reported by the USDA on Monday. Although this figure was up 13 percentage points since last week, it didn’t meet analysts’ expectations of 82% to 84%, which provided support for corn prices. Furthermore, this week’s sharp rebound in oil prices also was positive for corn, which gained ¢2/bu since the beginning of the week. Chart 12Chinese Investment Tailwind for Base Metals Chart 13Silver Could Temporarily Outpace Gold   Footnotes 1    Please see US Storage Tightens, Pushing WTI Lower, our forecast published last month on April 16, 2020, which discussed the production cuts agreed by OPEC 2.0 in April.  It is available at ces.bcaresearch.com. 2    Please see Oil highest since March as Chinese demand reaches 13 MMbpd published May 18, 2020, by worldoil.com. 3    Please see Reassessing the Oil Demand Impact of COVID-19 published by Kayrros on medium.com May 19, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights EM QE programs will ensure that EM local currency bond yields will drop further. However, the impact of these EM QE programs on EM currencies is ambiguous. Continue receiving long-term swap rates in a number of EM economies. QE programs globally constitute public debt monetization. A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. However, DM and EM QE programs could fuel financial market manias. Feature Chart I-1Broad Money Is Booming In DM And Accelerating In EM In this report we discuss the various quantitative easing programs (QEs) that have begun to surface in emerging economies. This is a new phenomenon that will likely mark a major precedent for EM central banks. Over time, these programs will likely become more prominent tools in EM. Understanding these unorthodox monetary policy easing measures in EM and DM is of paramount importance to investors. We use a Q&A format to discuss and elaborate on this topic. Question: What has forced the authorities to launch QE programs in EM and what forms have they taken? Answer: QE programs in developing countries are in their infancy. Several governments launched them in haste in the month of March in response to the recession and panic selloff that was occurring across global financial markets. These programs will be shaped by different forces and take different forms over time. Generally, QE programs are implemented in order to: (1) halt the abrupt deleveraging among local commercial banks amid the COVID-19 crisis (2) ensure credit continues to flow to the real economy (companies and households) (3) bring down long-term interest rates and prevent large government borrowings from crowding out the private sector. In addition to slashing policy rates, many EM central banks (CBs) are implementing one or more of the following initiatives to achieve these objectives: I.  Providing unlimited liquidity to commercial banks through various facilities II.  Buying government bonds III. Conducting direct purchases of local currency corporate bonds and, in some cases, mortgage-backed securities IV. Direct lending to non-banks such as mutual funds and enterprises V. Expanding the range of public and private sector securities that can be used as collateral when lending to banks The second, third and fourth types of operations can be considered forms of QE to the extent that they fall beyond the scope of customary CB operations. The latest QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. Table I-1 provides information about various central bank policies across mainstream EM countries. Details are still limited regarding the technicalities, quantity and timelines of some of these measures. Table I-1Quantitative Easing Policies Annouced By Emerging Economies Question: Do these QEs represent a public debt and fiscal deficit monetization? Answer: Yes, monetary and fiscal policies are being coordinated and these QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. These QE policies have been designed to ensure that the cost of government borrowing does not rise amid the surge in public sector borrowing requirements. Especially at a time when foreign investors were abandoning EM financial markets. Governments have deployed large fiscal stimulus packages to offset the devastating economic impact of COVID-19 induced shutdowns. Coupled with a collapse in fiscal revenues, this has resulted in a widening of fiscal deficits and large borrowing requirements. Chart I-2EM QEs Are Intended To Drive Down Local Bond Yields EM local currency government bond yields spiked in March (Chart I-2). This prompted CBs in many EMs to announce government bond purchasing programs in order to bring down government bond yields. Government bond yields influence other interest rates such as those for consumer and business loans. Higher borrowing costs amid a deep recession would have been lethal for corporate and household debtors. Additionally, it would have materially damaged public debt dynamics. To bring down government bond yields and ensure that policy rate cuts translate into lower borrowing costs across the entire yield curve, CBs have begun purchasing government bonds in the following developing countries: Brazil, South Africa, Poland, Colombia, India, Malaysia, Indonesia, Thailand and Korea. Government bond yields in many EMs have declined since mid-March (Chart I-2). That could be at least partially attributed to EM CBs’ QE programs. CB purchases of government bonds in either primary or secondary markets, qualify as public debt monetization. Question: How are QEs different from conventional CB operations and what makes them so unique as to warrant investor attention? Answer: There are three things that distinguish these QE initiatives from traditional CB operations: First, CBs do not typically lend to non-banks. They do not lend to or purchase credit instruments issued by non-banks. Hence, by purchasing corporate bonds and issuing loans to non-banks, CBs have entered into unchartered territory. This is also true for the Federal Reserve and CBs in other advanced economies. Second, by buying government bonds CBs are conducting an outright monetization of public debts and fiscal deficits. This is true for central banks in both EM and DM. Outside QEs, monetary authorities typically set the short-term interest rate and provide enough liquidity to the banking system to keep short-term interbank rates on par with policy rates. Chart I-3Fed’s Ownership Of Treasurys Prior to the launch of QE programs, CB operations with long-term government bonds were limited in scope and often technical in nature. For example, the Fed’s ownership of US Treasury securities rose by only 40% from $550 billion in 2002 to $775 billion in 2006. By comparison, it has doubled from $2 trillion to $4 trillion since September 2019 (Chart I-3). When CBs buy government bonds en masse, as they are currently doing in many countries, we are no longer talking about open market operations, but rather the monetization of public debt. Third, by launching QEs, CBs affect long-term interest rates. When financial markets are malfunctioning, which results in unjustifiably elevated long-term interest rates and cost of capital, QEs become essential to ensure the monetary policy transmission channel is operating effectively.  Nevertheless, as we have seen in the cases of the ECB and Bank of Japan, the use of QEs can become addictive. Once CBs have deployed QEs, they have a hard time abandoning them. When the financial systems and markets get accustomed to zero or negative nominal interest rates and to a constant overflow of CB liquidity, the termination of QEs will be disruptive and painful. Consequently, there is a risk that both DM and EM CBs will end up overdoing it with QEs - suppress long-term interest rates too much, for too long and for no justifiable reason. This will in turn lead to misallocations of capital, asset bubbles and other distortions in financial markets and real economies. If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise even if real output returns to its potential pace. Question: Is it fair to say that QEs lead only to an increase in commercial banks’ excess reserves at the CB, and that they have no real impact on the money supply? In other words, if commercial banks do not lend, is it true that the money supply will not expand and, thereby, QEs will never lead to higher rates of inflation?  Answer: Not really. QEs have a much more nuanced impact on the money supply. Moreover, the relationship between the money supply and the inflation rate is not straightforward. We will consider several examples, dissecting the impact of QEs on both excess reserves (ER) and the money supply. But first, let us recall that the broad money supply is the sum of both the cash in circulation and all types of deposits in commercial banks, including demand, time and savings deposits. Commercial banks’ ER at CBs are not included in either the narrow or broad definitions of money supply. Case 1: When a central bank purchases securities from or lends to a bank, ER rise although no deposit is created, so the money supply does not change.  Case 2: When a central bank purchases securities from or lends money to non-banks, this transaction creates both an ER and a new deposit in commercial banks, meaning that the money supply does increase. Case 3: When a commercial bank buys securities from or lends to non-banks, ER do not change while a new deposit is created “out of thin air”, so that the money supply rises. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e. the amount of deposits in the banking system) shrinks. To sum up, QEs lead to a larger money supply when CBs purchase assets from or lend to non-banks. When CBs purchase assets from banks, no new money (deposits) are created. Importantly, the money supply also expands when commercial banks buy securities from or lend to non-banks. Chart I-4A and I-4B reveal that QEs in the US, the UK, Japan and the euro area, over the past 10 or so, years have created a lot of ER but little money supply. Chart I-4AExcess Reserves Have Expanded More Than Broad Money In US, Japan… Chart I-4B… Euro Area And UK   In China, the broad money supply has been exploding since 2009. The commercial banks have, on their own, generated an enormous increase in the money supply “out of thin air”, by making loans to and buying securities from non-banks, even though there has been much less ER creation from the PBoC (Chart I-5). The top panel of Chart I-6 illustrates the remarkable evolution of broad money supply in China versus the US, the euro area and Japan. In the chart, broad money supply in these four economies is plotted along the same scale, since January 2009, when QEs began in DM and the credit boom commenced in China. Even though ERs have expanded much more in the US, the euro area and Japan (Chart I-6, bottom panel), broad money growth in China outstripped all other economies by a large margin (Chart I-6, top panel). Chart I-5Excess Reserves Have Expanded Less Than Broad Money In China Chart I-6Broad Money And Excess Reserves: China Versus DM     As we discussed in our previous reports on money, credit and savings, money supply growth is not at all contingent on savings in an economy. Rather, outside of QEs money in all countries is primarily created by the commercial banks when they lend to or purchase assets from non-banks. Still, the nature of QE is now changing in the US. Chart I-7 reveals that the broad money supply is booming faster than it ever has, since World War II. As the Fed lends directly to businesses and purchases corporate bonds that are largely held by non-banks, the money supply will explode in the US, alongside a surge in ER. Chart I-7US Money Growth: The Sky Is The Limit Chart I-8April Datapoints Suggest Notable EM Money Growth Acceleration Similar trends will occur in EM and other DM (Chart I-8): as their CBs buy securities from non-banks, they will simultaneously create both ER and new deposits at commercial banks (money supply). Question: Does this potential explosion in money supply globally – and in the US in particular – imply that there is an imminent risk of an inflation outbreak in the real economy? Answer: A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. Inflation (rising prices of goods and services) also depends on the velocity of money and the productive capacity of an economy. Nominal GDP = Velocity of Money x Money Supply In turn, Nominal GDP = Output Volume x Prices Hence, Output Volume x Prices = Velocity of Money x Money Supply Finally, Prices = (Velocity of Money x Money Supply) / Output Volume. Therefore, inflation is contingent not only on the money supply but also on the velocity of money and the output volume. The money supply will continue surging in the US and will boom in the rest of the world as other CBs also deploy QEs (Chart I-7 and I-8). However, the surge in money supply has so far been offset by a lower velocity of money (Chart I-9Aand I-9B). The velocity of money reflects the willingness of consumers and businesses to spend their money. Chart I-9AVelocity Of Money Dropped In March Chart I-9BVelocity Of Money Dropped In March If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise. In a nutshell, money growth will be booming worldwide due to QEs but the velocity of money, or the willingness to spend, will be the critical factor in determining inflation dynamics in the months and years to come. Question: Will the current excessive creation of money leak into asset prices and produce asset bubbles? Answer: It could. As we discussed in our January report titled, A Primer On Liquidity, an abundant money supply is conducive to higher asset prices and bubbles, but it is not a sufficient condition. Investors should be willing to allocate money to financial assets in order for the latter to appreciate. For example, since the beginning of this year, global risk assets have gone through an enormous roller-coaster ride. Through mid-February, risk assets were buoyant and the oft-cited rationale for the rally was plentiful liquidity. Then, from mid-February on through late March, we witnessed historic liquidity crunches across all financial markets, including US Treasurys. It is crucial to note that neither ER in the global banking system, nor global narrow and broad money slowed down during that period (Chart I-1 on page 1 and Charts I-4A and I-4B on page 6). Investors were simply liquidating financial assets and raising their cash level. Since late March, risk assets have been rallying as investors have felt more comfortable taking on more risk. Overall, whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Just as price inflation in the real economy is dependent on the willingness of consumers and businesses to spend their money on goods and services, financial asset price appreciation is contingent on the animal spirit of all investors and their inclination to take on more risk. Whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Question: How does the stock of US dollars (the broad money supply) compare with the value of US-denominated securities available to investors? Has the Fed’s purchases of securities not shrunk the amount of publicly-traded securities available to investors? Answer: Yes, indeed, they have. One of the distortions that the Fed’s and other CBs' QEs created has been the shrinkage of publicly-traded bonds and stocks. This has certainly lifted asset prices to levels they would have otherwise not reached. Chart I-10 plots the ratio of the US broad money supply-to-the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US denominated stocks and all types of bonds held by non-bank investors. It is calculated as the sum of the following: US equity market capitalization (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); and the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. Chart I-10The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The higher this ratio, the more US dollar deposits, or liquidity, is available per one dollar of market value of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, this ratio is somewhat elevated meaning that liquidity is relatively abundant. However, as argued above, animal spirits among investors are as important in driving financial asset prices as the amount of money supply. Question: What will happen to exchange rates in general, and to EM currencies in particular, given that almost every country in the world is expanding its money supply, simultaneously? Answer: There is no stable correlation between the relative money supply of two individual economies and their bi-lateral exchange rate. In addition, this is the first time that QEs are being deployed in both DM and EM countries at the same time. Therefore, there is no easy and straightforward answer to this question. Chart I-11EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? We recommend using the following framework to think about EM exchange rates versus the US dollar, at the moment: 1. EM currencies in aggregate will continue to be driven by global growth, as they have been historically. Chart I-11 illustrates that the EM ex-China currency index correlates with industrial commodity prices. The basis for this correlation is that they are both driven by the global business cycle. So far, the advance in both EM exchange rates and industrial commodities has been tame. It is still not clear if this is merely a rebound from very oversold levels or rather the beginning of a cyclical rally. 2. The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: US imports should expand, meaning that the US should send dollars to the rest of the world by buying goods and services. This has not yet happened though, as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. US investors should channel US dollars to EM to purchase EM financial assets. 3. From an individual EM perspective, there are several scenarios to consider: If a country’s QE: materially boosts its real growth, its currency will rally in spite of ongoing domestic QE; fails to meaningfully boost growth, its exchange rate will weaken; produces a rapid rise in inflation, its currency will depreciate; is used to finance unsustainable public debt dynamics, its currency will depreciate. As we have written in the recent reports, this could very well be the case in Brazil and South Africa. Investment Conclusions We expect EM local yields to fall further. For absolute-return investors we continue to recommend receiving swap rates in Korea, China, India, Malaysia, Russia, Colombia and Mexico. Our country allocation for EM local currency bond portfolios is always presented at the end of our reports on page 15. We continue shorting a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. However, if the strength in EM currencies persists in the near term, we will close our short positions. Continue underweighting EM equities and credit within global equity and credit portfolios, respectively. Within the EM credit space, favor sovereign to corporate credit. On that issue, please refer to our April 22, Special Report on EM foreign currency debt. For dedicated EM equity managers, we recommend overweighting Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Indonesia, India, the Philippines, the UAE, South Africa and Brazil. Please refer to our Open Position Table on page 14. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Underweight The S&P communications equipment index has given up its gains over the course of 2020. We remain bearish as the macro outlook still spells trouble and this positioning is in line with our newly formed view of preferring defensive tech (software & services) and avoiding aggressive tech (hardware & equipment). On the international front, “king dollar” has yet to fully filter through the system as foreign executives are reluctant to spend on big ticket items (CNY/USD shown advanced, top panel). On the domestic front, the industry has been aggressively ramping up headcount to the point that its wage bill is now expanding at the fastest pace this cycle. This rising labor cost backdrop will likely cap the share price ratio (wage bill shown inverted & advanced, middle panel) At the same time, CEOs are not ready to take the capex route as highlighted by the most recent CEO confidence survey (bottom panel). Importantly, the downtick in capex intentions came amidst a healthy rebound in almost every other “future conditions” sub-component of the survey. Bottom Line: Stay underweight the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV.

Highlights German bunds and Swiss bonds are no longer haven assets. The haven assets are the Swiss franc, Japanese yen, and US T-bonds. Gold is less effective as a haven asset. During this year’s coronavirus crash, the gold price fell by -7 percent. As such, our haven asset of choice for a further demand shock would be the 30-year T-bond, whose price rose by 10 percent during the crash. Technology and healthcare are the two sectors most likely to contain haven equities. Fractal trade: long Polish zloty versus euro. German Bunds And Swiss Bonds Are No Longer Haven Assets Chart of the WeekGold Is Tracking The US 30-Year T-Bond Price... But The T-Bond Is The Better Haven Asset European investors have been left defenceless. German bunds and Swiss bonds used to be the safest of haven assets. You used to be able to bet your bottom dollar – or euro or Swiss franc for that matter – that the bond prices would rally during a demand shock. Not in 2020. When the global economy and stock markets collapsed from mid-February through mid-March, the DAX slumped by -39 percent. Yet the German 10-year bund price, rather than rallying, fell by -2 percent, while the Swiss 10-year bond price fell by -4 percent.1  The lower limit to bond yields is around -1 percent. The reason is that German and Swiss bond yields are close to the practical lower limit to yields, which we believe is around -1 percent (Chart I-2). This means that German and Swiss bond prices cannot rise much, though they can theoretically fall a lot. Chart I-2German And Swiss Bond Yields Are Near Their Practical Lower Bound The behaviour of German bunds and Swiss bonds during the current crisis contrasts with previous episodes of market stress when their yields were unconstrained by the -1 percent lower limit. During the heat of the euro debt crisis in 2011, the 10-year bund price rallied by 12 percent. Likewise, during the frenzy of the global financial crisis in 2008, the 10-year bund price rallied by 7 percent (Chart I-3 - Chart I-5). Chart I-3German And Swiss Bonds Protected Investors During The 2008 Crash Chart I-4German And Swiss Bonds Protected Investors During The 2011 Crash Chart I-5German And Swiss Bonds Did Not Protect Investors During The 2020 Crash The defencelessness of European investors can also be illustrated via a ‘balanced’ 25:75 portfolio containing the DAX and 10-year German bund. The balanced portfolio theory is that a large weighting to bonds should counterbalance a sharp sell-off in equities, thereby protecting the overall portfolio. The theory worked well… until now. In this year’s coronavirus crisis, the 25:75 DAX/bund portfolio suffered a loss of -13 percent. This is substantially worse than the loss of -2 percent during the euro debt crisis in 2011, and the loss of -7 percent during the global financial crisis in 2008 (Chart I-6 - Chart I-8). Chart I-6A 25:75 DAX:Bund Portfolio Lost 7 Percent During The 2008 Crash Chart I-7A 25:75 DAX:Bund Portfolio Lost 2 Percent During The 2011 Crash Chart I-8A 25:75 DAX:Bund Portfolio Lost 13 Percent During The 2020 Crash What Are The Haven Assets? The lower limit to the policy interest rate – and therefore bond yields – is around -1 percent, because -1 percent counterbalances the storage costs of holding physical cash or other stores of value. If banks passed a deeply negative policy rate to their depositors, the depositors would flee into other stores of value. But if banks did not pass a deeply negative policy rate to their depositors, it would wipe out the banks’ net interest (profit) margin. Either way, a deeply negative policy rate would destroy the banking system. German and Swiss bond prices cannot rise much. German and Swiss bond yields are close to the -1 percent lower limit, meaning that the bond prices are close to their upper limit. Begging the question: what are the haven assets whose prices will rise and protect long-only investors when economic demand slumps? We can think of three. The Swiss franc. The Japanese yen (Chart I-9). US T-bonds. Chart I-9The Swiss Franc And Japanese Yen Are Haven Assets During the coronavirus crash, the 10-year T-bond price rallied by 4 percent while the 30-year T-bond price rallied by 10 percent (Chart I-10). Compared with German bund and Swiss bond yields, US T-bond yields were – and still are – further from the -1 percent lower limit. The good news is that long-dated T-bonds can still protect investors during a demand shock, although be warned that the extent of protection diminishes as yields get closer to the lower limit. Chart I-10Long-Dated US T-Bonds Are Haven Assets What about gold? As gold has a zero yield, it becomes relatively more attractive to own as the yield on other haven assets declines and turns negative. In fact, through the last three years, the gold price has been nothing more than a proxy for the US 30-year T-bond price (Chart of the Week). But gold is an inferior haven asset. During the coronavirus crash, the gold price fell by -7 percent, meaning it did not offer the protection that T-bonds offered. As such, our haven asset of choice for a further demand shock would not be gold. It would be the 30-year T-bond. What Are The Haven Equities? Many investors still use (root mean squared) volatility as a metric of investment risk. There’s a big problem with this. Volatility treats price upside the same as price downside. This is unrealistic. Nobody minds the price upside, they only care about the downside! Hence, a truer metric of risk is the potential for short-term losses versus gains. This truer measure of risk is known as negative asymmetry, or negative skew. In the twilight zone of ultra-low bond yields, bond prices take on this unattractive negative skew. As German bunds and Swiss bonds have taught us this year, bond prices can suffer losses, but they cannot offer gains. This means that bonds become riskier investments relative to other long-duration investments such as equities whose own negative skew remains relatively stable. The upshot is that the prospective return offered by equities must collapse. This is because both components of the equity return – the bond yield plus the equity risk premium – shrink simultaneously.  Equity valuations rise as an exponential function of inverted bond yields. Given that valuation is just the inverse of prospective return, the effect is that equity valuations rise as an exponential function of inverted bond yields. Chart I-11 illustrates this exponentiality by showing that technology equity multiples have tightly tracked the inverted bond yield plotted on a logarithmic scale. Chart I-11Technology Valuations Are Exponentially Sensitive To The (Inverted) Bond Yield Unfortunately, not all equities will benefit from this powerful dynamic. Equities must meet two crucial conditions to justify this exponential re-rating. One condition is that their sales and profits must be relatively resilient in the face of the current coronavirus induced demand shock. And they should not be at risk of a structural discontinuity, as is likely for say airlines, leisure and many other old-fashioned cyclicals. A second condition is that their cashflows must be weighted further into the future, so that their ‘net present values’ are much more geared to the decline in bond yields. Equities that meet these two conditions are likely to benefit the most from the ongoing era of ultra-low bond yields. And the two equity sectors that appear the biggest beneficiaries are technology and healthcare. In the coronavirus world, these two sectors will likely contain the haven equities. Stay structurally overweight technology and healthcare. Fractal Trading System* This week’s recommended trade is to go long the Polish zloty versus the euro. The profit-target and symmetrical stop-loss are set at 2 percent. Most of the other open trades are flat, though long Australian 30-year bonds versus US 30-year T-bonds and Euro area personal products versus healthcare are comfortably in profit.  The rolling 1-year win ratio now stands at 61 percent. Chart I-12PLN/EUR When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 From February 19 through March 18, 2020. 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