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Your feedback is important to us. Please take our client survey today. Highlights The signaling of QE programs by central banks has the greatest short-term impact on financial markets. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created excess reserves and deposits, respectively. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Therefore, going forward QE programs will have a greater impact on financial markets than they did in the past ten years. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation in the coming years. Rising velocity of money will be the key to inducing and sustaining higher inflation. Feature There are varying explanations in the investment community over how quantitative easing (QE) programs affect asset prices and consumer price inflation. For example, investors often struggle to dissect the impact of QE on equity prices and exchange rates: (1) Is it the level of central bank assets or their rate of change that affects financial markets? or (2) Is it the signaling mechanism of QE that moves asset prices and currencies? (3) Why did QE programs in the last decade not lead to higher consumer price inflation? We use a question-answer format to elaborate on these and other questions related to QE programs.  QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. Question: Do QE programs amount to money printing? Answer: Not always. QE operations by central banks might or might not create new money supply. First, we have to define money. In all countries, broad money supply is commonly defined and calculated as the sum of cash in circulation and all types of deposits in the commercial banking system. Cash in circulation makes only 11% of broad money supply in the US, 9% in the euro area, 3.8% in China and 7.3% in Japan. Hence, various types of deposits in commercial banks constitute the overwhelming portion of broad money supply. Deposits in commercial banks are not a part of a central bank’s balance sheet. Therefore, neither central bank assets nor liabilities are valid measures or proxies of money supply. Chart I-1A and I-1B illustrates that changes in central bank assets and broad money supply have contrasted greatly.     Chart I-1ACentral Bank Assets ≠ Money Supply Chart I-1BCentral Bank Assets ≠ Money Supply   When central banks expand their balance sheets, they create excess reserves (ERs) “out-of-thin air”. ERs are commercial bank deposits at the central bank. There is a close relationship between ERs and central bank balance sheets as ERs constitute a large part of the latter’s liabilities. As a mirror image of ERs, the asset side of central banks’ balance sheet expands as they acquire securities or originate loans.  However, ERs are not a part of either narrow or broad money supply. In fact, in the last decade QE programs in the US, Japan and the euro area created a lot of ERs but little money supply as can been seen in Chart I-2A and I-2B. Chart I-2ATrends In Excess Reserves And Money Supply Differ Chart I-2BTrends In Excess Reserves And Money Supply Differ   In China, it was the opposite: commercial banks have created a lot of money and expanded their assets even as the central bank has provided little ERs (Chart I-2B, bottom panel).  ERs are liquidity for the banking system; commercial banks use ERs to settle payments among themselves and with the central bank. ERs do not spill over into the real economy as commercial banks do not lend out ERs to companies and households. When a central bank buys securities or lends money, it always creates ERs but it does not always create money supply. Households, companies, non-bank financial institutions, organizations and governments (hereafter, economic agents) use money supply – deposits in the banking system and cash in circulation – to buy goods, services and assets. They do not have access to or do not use ERs. Given that central bank QE operations create ERs but not always money supply (deposits), they have a much more nuanced impact on the money supply. Question: In which cases do QE operations create money supply (or not)?  Answer: Whether a QE operation will lead to money creation depends on the counterparty of the central bank transaction: 1. When the central bank lends to or buys securities from commercial banks, it creates ERs but not money supply (deposits). In this case, the central bank’s balance sheet expands but the amount of deposits/money supply in the banking system does not change (Figure I-1). Figure I-1 This operation creates ERs (liquidity for the banking system) but not money supply/deposits at banks that economic agents can use to purchase goods, services, and assets. That said, commercial banks with a large quantity of ERs might decide to originate more loans/lend more to economic agents so that money supply (purchasing power) can expand. In this scenario, QE operations do not affect money supply directly, but they may do so indirectly. 2. When the central bank lends to or purchases securities from economic agents, both ERs and new money supply/deposits are created “out of thin air” (Figure I-2). In this case, not only do commercial banks get ERs but economic agents also get deposits that did not exist before. These newly created deposits constitute an increase in money supply and boost the purchasing power of these economic agents. Figure I-2 3. Absent QE operations, central banks do not typically directly alter money supply; money is almost entirely created by commercial banks. When a commercial bank buys securities from or lends to economic agents, ERs do not change but a new deposit is created “out of thin air”, therefore the money supply expands. 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, QE operations create new money (deposits at commercial banks) when central banks purchase assets from or lend to non-banks. When central banks purchase assets from commercial banks, no new money is created. Importantly, the main source of money creation outside QE programs is commercial bank purchases of securities from or loans to economic agents. Changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies. Question: How can we forecast if any particular QE program is going to create more or less money? Answer: There is no way to predict it. All depends on the counterparties involved in central bank transactions. One can only observe the evolution of money supply to gauge the direct impact of a QE program on money supply. Further, commercial bank actions have a great deal of impact on money supply. When the commercial banking system as a whole shrinks its assets (loan book, holdings of securities and other claims or assets), money supply contracts, ceteris paribus. In short, to forecast changes in money supply one need to not only forecast central bank transactions with economic agents (non-banks) but also commercial banks loans to, and purchases of securities from, economic agents. Chart I-3Broad Money Growth: Now Versus Last Decade Question: In regard to their impact on money supply, how do QE programs presently differ from those of the last decade? Answer: The key difference between the outcomes of QE programs this year and the ones undertaken in the last decade is that broad money growth in advanced economies is skyrocketing now but it was tame during the QE programs of the last decade (Chart I-3). To recap, QE programs in the US, Japan and the euro area, over the past 10 or so years have created a lot of ERs but little money supply. The reasons for this are as follows: deleveraging by banking systems in the last decade – commercial banks assets shrank or grew modestly – partially offset QE operations’ boost to money supply. Chart I-4 illustrates commercial banks’ assets contracted in 2009-10 in the US, in 2012-17 in the euro area and in the 1990s in Japan. Shrinking commercial bank assets reduces money supply, ceteris paribus. That is why QE programs of the last decade had a muted impact on broad money supply. Presently, commercial banks assets are rising rapidly in the US, the euro area and Japan. Hence, the simultaneous expansion of both central bank and commercial banks assets ensures much more robust money growth now than during the past two decades. Further, advanced economies are moving from monetary to fiscal dominance as their fiscal policies become much more proactive in stimulating growth. This entails running larger fiscal deficits. Mushrooming government bond supply will have to be absorbed by central banks to preclude a substantial rise in bond yields that can threaten economic expansions. Consequently, central banks will purchase a lot of government bonds not from commercial banks but from governments or other investors. This will directly boost money supply. Finally, commercial banks in DM have plenty of ERs and they do not need to sell their bonds in exchange for ERs like they did when they deleveraged last decade. Hence, DM central banks will primarily be purchasing bonds from non-banks resulting in new money creation. All in all, money supply in advanced economies will grow much faster this decade than it did in the past ten years.       Question: Does the current booming money supply in the US not reflect an overflow of excess savings? Answer: As we discussed in our previous reports on money, credit and savings, changes in money supply are not at all contingent on national or household savings. As was discussed above, outside of QE operations, money is primarily created by commercial banks “out-of-thin air” when they lend to or purchase assets from non-banks. Chart I-5 illustrates that there has been no positive correlation between the savings rate and money supply in China, Korea, Japan and the US. The same holds true for any other economy. Chart I-4Commercial Bank Assets Have Great Impact On Money Supply Chart I-5National Or Household Savings Do Not Drive Changes In Money Supply Chart I-6The US: Household Savings Rate And Money Supply The reason why the surge in US money supply this year has coincided with the rise in the US savings rate is as follows (Chart I-6): the Federal Reserve bought an enormous amount of US Treasury securities creating new money “out of thin air”; households received these fiscal transfers from the government in their bank accounts in the form of deposits. Hence, new money was created as a result of public debt monetization and this occurred before consumers made their choice between spending and saving. Critically, changes in economic agents’ propensity to save are reflected not in money supply but in the velocity of money. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. In brief, changes in the propensity to save alter the velocity of money, but not the amount of money supply. Chart I-7Velocity Of Money Explains Changes In Core Inflation Question: What is more important to inflation in goods and services: money supply or the velocity of money? Answer: Empirical evidence shows that the changes in the velocity of money explain fluctuations in core consumer price inflation much better than money growth in major economies (Chart I-7). Overall, there is no direct link between interest rates and money supply on the one hand and goods and service inflation on the other hand. That said, low interest rates or rapid money growth might encourage economic agents to save less, i.e., spend a larger share of their income. Stronger spending – which leads to an acceleration in the velocity of money – will raise inflationary pressures in the real economy. Even if QE programs succeed in generating rapid money growth, the latter does not automatically bring about higher inflation in goods and services. The willingness of consumers and businesses to consume more is critical to generating consumer and producer price inflation. Question: How does money supply differ from liquidity that flows into financial markets? Answer: Investors and market commentators often refer to “liquidity” as a driving force for financial markets. Yet definitions and calculations of liquidity vary tremendously. What investors refer to as “liquidity” can by and large be classified into three groupings: (1) banking system liquidity (excess reserves); (2) broad money supply (all deposits and cash in circulation) available to purchase goods, services and assets, including securities; and (3) liquidity in asset markets – the portion of broad money supply that is channeled to purchase financial assets. Figure I-3 provides a visual representation of money supply and liquidity groupings. All other measures of “liquidity” generally fall into one of these three groupings. Figure I-3Liquidity Groupings And Linkages Deposits/money supply can be used to acquire both financial and real assets as well as to purchase goods and services. They could also be kept idle. In a given period of time, it is impossible to envisage what portion of deposits in the banking system will be allocated to securities investments. Ultimately, this decision rests with each individual and institutional investor. Therefore, it is impossible to forecast the true size of liquidity flow into and out of asset markets. Chart I-8Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Overall, gauging liquidity flows to asset markets boils down to predicting investor behavior. Liquidity flows into financial assets when “animal spirits” among investors improve. In contrast, deteriorating investor confidence can lead to a dearth of liquidity in asset markets, despite abundant broad money supply. This topic of liquidity flows into and out of financial markets was extensively discussed in our report titled A Primer On Liquidity. Question: Is there a shortage of financial assets relative to available liquidity? Answer: Probably yes. QE programs in advanced economies have removed high-quality financial assets – valued at about $22 trillion – from global markets. Yet, money supply has expanded tremendously. This has left more money chasing few assets. The top panel of Chart I-8 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines – presently stand at $4 trillion. Notably, the Fed and US commercial banks have increased their debt securities holdings by $3.2 trillion since February and are currently holding $10.9 trillion of debt securities (Chart I-8, middle and bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. We reckon that cash on the sidelines is equal to 8% of the combined value of US equities and US-dollar debt securities available to non-bank investors, i.e. excluding debt securities owned by the Fed and commercial banks (Chart I-9). There is room for this ratio to drop further to its January 2020 level. Chart I-9Investors' Cash Holdings Ratio Has Room To Drop Further To recap, the amount of liquidity flowing into and out of financial assets is ultimately contingent on investor behavior. When investors are willing to invest, liquidity flows into asset markets. On the contrary, when investors turn cautious, they withhold liquidity and asset prices drop.   Overall, barring negative shocks and relapses in growth, risk assets will be supported by tailwinds of expanding money supply. Conclusions And Investment Strategy The signaling of QE programs by central banks has the greatest short-term impact on financial markets – positive on risk assets and negative on the exchange rate. However, the staying power of that impact depends on how fast QE operations expand money supply and what commercial banks and economic agents do with newly created ERs and deposits, respectively. Besides, the amount of securities withdrawn from circulation by central banks relative to assets under management also determines the impact of QE operations on asset prices. QE programs in 2020 are creating more money supply, i.e. more potential purchasing power for goods, services and assets, than did QE programs of the last decade. Going forward, QE programs will have a greater impact on financial markets than they did in the last decade because they will create more money supply (Chart I-10). Besides, as central banks absorb more securities, the availability of securities to private investors will decline. This will be especially pertinent if the pool of assets under management expands faster along with rapidly growing money supply. This ceteris paribus warrants high asset prices. Interestingly, Chart I-11 demonstrates that during the last decade there was no positive correlation between G4 QE programs - central banks’ balance sheets - and EM risk assets and currencies. Based on this Chart I-11, during the last decade we often downplayed the importance of QE programs for EM financial markets. Chart I-10Global Money Does Not Always Drive Share Prices Chart I-11DM Central Banks' Assets And EM: No Correlation In The Last Decade   However, we have changed our view on the impact of the current round of QE programs on financial markets since May when we published a report titled Understanding QE Programs In EM And DM.  3. Considerably faster money creation increases the odds of meaningfully higher goods and services inflation. A rising velocity of money will be the key to inducing and sustaining higher inflation. De-globalization, policies targeting income redistribution from high- to low-income households, and the oligopolistic structure of a growing number of industries all argue for higher price inflation in the real economy this decade. Only technological advances and automation will be working the opposite way and thus keeping a lid on consumer price inflation. In short, odds favor higher inflation this decade.  4. Concerning EM financial markets, QE programs in EM and DM are especially positive for EM local currency bonds and sovereign and corporate credit markets. We remain long duration in EM domestic bonds but neutral on their currencies versus the US dollar. We expect a rebound in the US dollar before the end of this year. We will use this rebound in the greenback to recommend investors to be long local bonds without hedging currency risk. As for EM credit markets, we are neutral and expect to buy on a dip. The ability of governments to finance themselves locally will limit the supply of US dollar bonds and support this asset class. The latter will also benefit from DM QE programs. While EM and DM QE programs can meaningfully affect the trend in share prices and currencies, the primary long-term trend in EM equities and exchange rates will depend on the return on capital in their respective economies. A high or rising return on capital will supercharge share prices and lead to substantial currency appreciation. A low or plunging return on capital will weigh on both stock prices and currencies, regardless of QE programs. Equity investors should remain neutral on EM equities versus DM. We are presently short a basket of EM currencies versus the euro, CHF and JPY. For country allocation with equities, local bonds, credit markets and currencies, please refer to tables at the end of each report (pages 17-18). The signaling of QE programs by central banks has the greatest short-term impact on financial markets. 5. Finally, Chart I-12 presents a graph that combines two variables: the increase in broad money supply since February as a share of GDP (X-axis) and each country’s central bank purchases of government bonds as a share of net government bond issuance since February (Y-axis).  Chart I-12Monetization Of Fiscal Deficit And Rapid Money Growth This chart gauges the degree of public debt/fiscal deficit monetization by central bank QE operations and aggregate money creation by the central bank and commercial banks. It reveals that the US, the euro area, the Philippines and Poland since February have experienced a money boom stemming from their central banks buying government bonds. India and Turkey are a notch below them. In the majority of EM countries, central bank QE programs and money creation by banks have been timid. This confirms our theme that the majority of EM except China, Korea, and Taiwan are facing tight budget constraints. This will slow down a recovery in these economies. However, it will also force companies and commercial banks to restructure and boost efficiency. The ones that undertake such restructuring will enjoy a bull market in share prices and their currencies will appreciate in the long run.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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Highlights Under the newly released deleveraging policies, Chinese real estate developers have no choice but to deleverage. Over the next six months, the most likely scenario will be moderate growth in property sales, starts and completions, but a drop in land purchases. We expect Chinese onshore and offshore property stocks to continue underperforming their respective benchmarks. However, we recommend buying Chinese property developers’ offshore corporate bonds. Feature The country’s real estate sector has exhibited clear signs of improvement. As both commodity buildings’ floor space starts and sales showed four consecutive months of year-on-year growth, Chinese real estate investment has returned to its pre-pandemic annual rate of acceleration (Chart 1). In addition, our broad measures of Chinese real estate construction activity – the “building construction” floor area starts and completions – have also rebounded sharply (Chart 2). Chart 1Chinese Property Market: A Sustainable Recovery Ahead? Chart 2Sharp Rebound In Post-Pandemic Construction Activity One driving force behind the real estate sector’s recovery was that China loosened up its monetary policy and implemented fiscal stimulus earlier this year. However, since July, the government has implemented a flurry of restrictive policies to clamp down on flows of capital into the real estate sector, and has repeatedly stressed the mantra: “Houses are for living in, not for speculation.” Most importantly, in late August the government released a framework mandating Chinese property developers to deleverage. As Chinese homebuilders have no choice but to reduce their debt load, will the property market recovery continue? Chart 3Constrained Financing May Lead To A Drop In Land Sales Going Forward Over the next six months, we expect a 4-6% year-on-year growth in property sales. The government-set deleveraging mandate will likely result in considerable property sales promotion by real estate developers. In the meantime, faced with constrained financing, homebuilders may prioritize completion of already sold but unfinished buildings over land investment (Chart 3). This may result in a moderate pickup in construction activity, but a drop in profit margins and land sales. Beyond the next six months, property sales in China will likely struggle to grow, as price discounts may not be enough to outweigh demand headwinds. In turn, construction activity may falter, as the government-led deleveraging mandate and weakening sales will curtail the cash flow to homebuilders.  Mandated Deleveraging Chart 4Property Developers Will Have No Choice But To Deleverage The Chinese real estate sector is highly indebted. According to the National Bureau of Statistics of China, the sector’s total liability-to-asset ratio rose to 80%, and its debt-to-equity ratio was at 4.1 by the end of last year (Chart 4). Policymakers in Beijing well recognize that excesses in the property market in general, and leverage among property developers in particular, constitute a major risk to financial stability. As part of the strategy to establish a long-term, sustainable mechanism for the real estate sector, the Chinese central bank and the housing ministry issued a framework – essentially a deleveraging mandate for Chinese property developers. This framework includes Three Red Lines and Four Tiers. Three Red Lines There will be a 70% ceiling on liabilities to assets, excluding advanced payments from presold houses; The net debt-to-equity ratio needs to be less than 100%; Short-term borrowings cannot exceed cash reserves. Four Tiers Companies that exceed all three red lines are placed into the red tier, while those passing any two of the three red lines are in the orange tier and enterprises that cross one of the three lines are in the yellow tier. Firms with financials within the three red lines are classified in the green tier. The government is using these debt tiers to control which firms will have access to new financing and how much new financing they can apply for. Failing to meet all three “red lines” (i.e., the red tier) may result in them being cut off from access to new loans from banks. If a firm passes all three red lines (i.e., the green tier), it can increase its debt up to a maximum of 15% in the next year. If it is in the yellow or orange tier, it can increase its debt up to a maximum of 10% and 5% in the following year, respectively (Table 1). Table 1The Mandated Deleveraging Framework: Three Red Lines And Four Tiers Enterprises that break all three red lines are required to submit a report on their debt-reduction plan, listing their planned deleveraging measures to reduce the number of red-line breaches within one year, as well as the planned measures to reach the green tier within three years. Based on the 2020 mid-year data released by 100 major public-traded property-developing companies listed as either A-shares or H-shares, 86% of them are breaking at least one of the red lines, 22% of them are breaching all three red lines and only 14% of them are in the green tier. Bottom Line: Chinese home developers are set to embark on the deleveraging path due to the new regulation. This will limit their access to financing and has implications for their activity and, thereby, the overall economy. What Does This Mean? Property development is an asset-heavy and capital-intensive business, and this industry typically relies a lot on debt. Chart 5Chinese Real Estate Investment: A Breakdown Of Funding Source There are several ways for homebuilders to finance themselves. Chart 5 shows the breakdown of the source of Chinese real estate investment funding, with 15.5% of the total funding from domestic and foreign loans, 32% from a self-raising fund through issuances of bonds or equity, 33.2% from deposits and advanced payments, and 16.2% from homebuyers’ mortgages.  With limited financing from the loan and bond markets, the country’s real estate developers will have to seek more financing from deposits and advanced payments, homebuyers’ mortgages and equity issuances. Chart 6Property Developers Need To Boost Their Sales To Raise More Cash As equity issuance dilutes existing shareholders' profits and drives down share prices, developers often opt for presales to raise financing, i.e., they pre-sell more properties to increase their revenue from deposits and advanced payment, as well as mortgages (Chart 6).  Hence, in the short term, i.e., over the next six months, many property developers may need to cut home prices to boost their sales and shore up cash for their operations. For example, the country’s biggest real estate developer – Evergrande – falls short on all three metrics and lies in the red tier. The company announced in early September that it would do aggressive sales of properties by lowering the selling prices for all types of properties by 30% across the country during the period of September 7 to October 8. Indeed, the company’s sales reached a record high for this period. The aggressive sales promotion of properties will encourage demand. We expect the year-on-year growth of floor space sales to reach 4-6% over the next six months – an acceleration from 1.3% during the pre-pandemic period of 2H2019, but a moderation from the 6.4% growth in the post-pandemic months (Chart 7). Beyond the next six months, home sales may struggle to grow as the impact from price discounts diminishes and demand will face the following headwinds:  The authorities continued to show their determination to crack down on speculative housing demand. Stricter policies, including tighter restrictions on both first and second home purchases and mortgage applications, as well as raising the down payment ratio, have been implemented recently in cities experiencing a rapid rise in property prices, such as Shenzhen, Hangzhou, Tangshan, Zhengzhou and many other cities. The government also set new bank lending regulations to the real estate sector; new bank loans issued to the real estate sector, measured as a share of total new bank loans, should be kept under 30% of total banks’ loans (Chart 8). The ratio has declined to the current 25% from 30-50% in the past four years. We believe the ratio will remain below 30% over the next six to twelve months. Chart 7Chinese Property Sales, Starts And Completions Will Grow Moderately In Coming Months Chart 8Constrained Lending To Chinese Real Estate Sector From Banks Lending to the real estate sector includes housing mortgages and loans for real estate development. The capped bank loans to the property sector suggests that tighter lending standards will be applied to mortgage loans as well as property development loans. This will likely curb demand for housing. The authorities stopped the Pledged Supplementary Lending (PSL) program in 2020. The PSL was a driving force behind property demand in China during 2015-2018, but this time the government has refrained from PSL injections. The government-subsidized shantytown renovation program (e.g., adding elevators, building parking spots, painting interior and exterior walls, paving roads, etc.) will reduce demand for new properties. With improved living conditions, some households may not need to buy new properties. The government’s renovation project covers 7 million houses this year, of which 76.4% (5.4 million) were completed during the first eight months of this year. Moreover, a renovation project of a similar scale will be implemented next year.   The government’s active promotion of rental housing will also reduce the demand for new housing. Rental prices have been falling due to the pandemic, and that may delay home buyers from purchasing residential properties.    Chart 9Chinese Property Demand Faces Structural Headwinds The Chinese property market also faces strong structural headwinds. For example, property demand in China has already entered a saturation phase, and the working-age population (15-64 years of age) is shrinking (Chart 9). What about the outlook of property starts and completions? Constrained net borrowing will weigh on floor space starts and floor space completions. As such, we only expect moderate growth (i.e., smaller than 5%) in both property starts and completions over the next six months (Chart 7 on page 6). With constrained financing, homebuilders may have to allocate an increasing amount of funding to complete their unfinished projects instead of purchasing new land (Chart 3 on page 2). The pace of property completion has to catch up with both sales and starts. Property developers are currently under increased pressure to deliver units that were pre-sold about two years ago (Chart 10). Rising property sales will provide more financing for the developers to complete these projects under construction. The moderate growth in floor space starts and completions will lift construction activity slightly in the commodity buildings market (Chart 11). Chart 10Homebuilders Need To Deliver Their Unfinished Projects Chart 11Construction Activity In China: Moderate Increase Ahead That said, construction activity may relapse beyond the next six months. Both the enduring government-led deleveraging mandate and weakening sales will lead to funding shortages for Chinese homebuilders to carry on new construction projects. Bottom Line: Floor space sales, starts and completions will expand moderately despite the mandated deleveraging of developers in the next six months.  Investment Implications First, it is reasonable to expect a moderate pickup in real estate construction activity in China over the next six months. This will be marginally positive for construction-related commodities demand.  Chart 12Commodity Prices: Hold A Neutral Stance For Now However, commodity prices have already rebounded sharply since April, and China's infrastructure-related construction activities usually peak in October. Therefore, a marginal increase in commodity demand from the real estate sector is not a catalyst for further price increases in commodities such as steel, cement, and glass. For now, we prefer to hold a neutral stance on these commodities (Chart 12).  Beyond six months, the possibility of negative growth in home sales, starts and construction is rising, raising warning signs for construction-related commodities demand. Second, property developers may cut their land purchases in order to allocate more funds to completing unfinished homes. This heralds that a drop in the local government’s revenue may lie ahead. This will have ramifications for their spending in 2H2021. Third, regarding property stocks, they have been moving sideways in absolute terms this year, having significantly underperformed the benchmark (Charts 13 and 14). This reflects their poor profit growth prospects and weak financial fundamentals. We expect the Chinese property stocks to continue to underperform their benchmark, as the aggressive selling strategy will reduce companies’ profit margins. Chart 13Chinese Property Stocks: A Tapering Wedge In Absolute Terms, And… Chart 14…Continuing Underperformances Relative To Their Respective Benchmarks Lastly, we recommend buying Chinese offshore real estate bonds, as moderate growth recovery in the country’s real estate sector and deleveraging will lead to a narrowing of the sector’s corporate spread. In addition, the ongoing global search for yields will intensify the demand for high-yield bonds.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

  Chart Of The WeekInvestor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets.   The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively.  In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well   Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted   A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy   The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering   China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy   China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth   China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking?   Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances   Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance?   These Markets Have Not Yet Entered A Bull Market  These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market   Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency   EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations