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Highlights The US dollar is likely to weaken over the next 12 months as global growth accelerates and the narrowing in real interest rate differentials continues to thwart the greenback. Theoretically, the relationship between exchange rates and budget deficits is indeterminate. Whether or not a larger budget deficit leads to a weaker currency ultimately depends on how the central bank responds and what other countries are doing. Today, the Fed is effectively capping nominal yields through unlimited bond purchases and aggressive forward guidance. As such, the passage of a new US fiscal stimulus package should mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. While a disorderly dollar selloff cannot be ruled out, it is a low-probability scenario at the moment. A major dollar decline would require that realized inflation increases dramatically, which is unlikely at a time when unemployment is still so elevated. Moreover, to the extent that the US economy is operating below its potential, increased fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will limit any deterioration in the current account balance. Investors should remain overweight global equities over a 12-month horizon, favoring cheaper non-US stocks and cyclical sectors. Beep Beep In the classic Road Runner cartoon, Wile E. Coyote has a habit of inadvertently running off a cliff, stopping for a moment in mid-air to look down, only to realize that there is nothing beneath him. Like the coyote, the US economy has gone over the fiscal cliff. The extra $600 a week in emergency federal unemployment benefits have lapsed. The small business Paycheck Protection Program has stopped accepting new applications, while state and local governments face a massive cash crunch. President Trump’s executive orders, if implemented, will mitigate some of the fiscal tightening. However, it is probable that they will be challenged in court. And even if the states are able to get the new unemployment benefit program up and running quickly – which seems doubtful – the $44 billion in federal funding for the program, which was taken from the Department of Homeland Security’s Disaster Relief Fund, will run out in six weeks. The stimulative effect of the adjustment to payroll taxes is also likely to be limited, given that the President’s order only defers tax liabilities until next year, rather than forgiving them altogether. So why hasn’t the stock market reacted negatively to the withdrawal of large-scale fiscal stimulus? The answer is that investors are assuming that Congress will manage to cobble together a deal over the coming days that resolves the shortcomings in Trump’s executive orders. Given that voters favor more stimulus, some sort of a deal is more likely than not (Table 1). However, with the stock market near record highs, the impetus for Trump to seek a compromise with Congress is not yet at hand. Risk assets may need to suffer a setback to catalyze an agreement. Table 1Majority Continues To Support Expanded Unemployment Insurance Still Sticking With Our Overweight 12-Month View On Stocks Despite our near-term concerns, we continue to recommend that investors overweight equities on a 12-month horizon. While stocks are not particularly cheap, they are not expensive either. The MSCI All-Country World index is trading at 18-times calendar 2021 earnings. The forward PE ratio based on projected 2021 earnings is 21 in the US and 15 outside the US. Even if one allows for the likelihood that earnings estimates are overly optimistic – as they usually are – the earnings yield on stocks is about six percentage points above the real yield on bonds. This suggests that the equity risk premium is still quite high, compensating investors for earnings risk (Chart 1). Meanwhile, sentiment towards stocks remains downbeat. Bears outnumbered bulls by 12 percentage points in this week’s American Association of Individual Investors sentiment poll (Chart 2). On average, bulls have exceeded bears by 8 percentage points in the 33-year history of this survey. Stocks are more likely to go up than down when sentiment is bearish. Chart 1Favor Equities Over Bonds Over A 12-Month Horizon Chart 2Many Investors Are Bearish On Stocks Dollar: Stick With The Herd Chart 3The Dollar Has Started Breaking Down Bears also outnumber bulls in surveys of sentiment towards the dollar (Chart 3). Does that mean that one should position for a stronger greenback? No. The dollar is a high momentum currency (Chart 4). Unlike in the case of equities, being a contrarian has been a losing strategy for trading the dollar. The dollar is more likely to weaken when sentiment is bearish and the currency is trading below its moving averages, as is currently the case (Chart 5). Chart 4The Dollar Is A High Momentum Currency Chart 5Trading The Dollar: The Trend Is Your Friend The US Dollar Is Normally A Risk-Off Currency Chart 6The US Economy Is Less Cyclical Than Those Of Its Trading Partners What are the implications of a weaker dollar for risk assets? Just like bond yields can either fall for risk-on reasons (i.e., when monetary policy turns dovish) or fall for risk-off reasons (i.e., when deflationary pressures set in), a weakening in the US dollar can either be a risk-on or a risk-off event. Historically, the dollar has traded as a risk-off currency. This is partly because the US Treasury market is one of the most liquid and safest in the world. When investors panic, they flock to Treasuries, which raises the demand for dollars. In contrast, when investors feel emboldened to take on more risk, they tend to sell dollars. The US economy is less cyclical than those of its trading partners (Chart 6). While the US benefits from stronger global growth, the rest of the world benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, hurting the dollar in the process. Moreover, changes in interest-rate differentials can affect the value of the dollar. For example, at the start of 2019, euro area 2-year real rates were 221 basis points below comparable US rates. Today, they are 19 basis points above US rates, representing a net swing of 240 basis points. If anything, the dollar has fallen less than one would have anticipated based on changes in interest rate differentials (Chart 7). Chart 7AInterest Rate Differentials Do Not Favor The Dollar Chart 7BInterest Rate Differentials Do Not Favor The Dollar Will Bloated Fiscal Deficits Undermine The Dollar? To the extent that the recent dollar selloff has been driven by stronger global growth and a more dovish Fed, it is not surprising that risk assets have rallied. However, an increasing number of commentators have begun to wonder whether the next leg of the dollar bear market could be less benign than the one that preceded it. The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Stephen Roach has argued that soaring budget deficits will push the US current account further into deficit, while America’s disengagement from the rest of the world will undermine the dollar’s reserve status. He reckons that the dollar could plunge by 35% “sooner rather than later.” I agree with Stephen that the dollar faces a variety of long-term challenges. However, I do not think these challenges will be the primary drivers of the dollar over the next 12 months or so. A Simple Framework For Thinking About Currencies To understand why, let me describe a simple two-country framework that I have found to be very useful for thinking about currencies’ sensitivity to various macroeconomic forces. This framework, which draws on the seminal work of Rudi Dornbusch in the 1970s,1 relies on two “equilibrium conditions”: A long-run equilibrium condition that says that the price of a comparable basket of goods and services should be the same across countries. This implies, for example, that if the price level in Country A rises relative to Country B by say 10%, then Country A’s currency should eventually depreciate by 10% relative to Country B’s. A short-run equilibrium condition that says that the expected risk-adjusted return on investment assets should be the same across countries. This implies that all excess returns are arbitraged away. Suppose that interest rates and inflation are initially the same in Country A and B, but that A suddenly and unexpectedly decides to run a larger budget deficit for the next ten years. What will happen to the value of A’s currency? The answer depends on how Country A’s central bank reacts; specifically, on whether real interest rates end up going up or down in response to the bigger budget deficit. First, let us consider an extreme situation where investors believe that Country A’s central bank will not hike interest rates at all in response to the larger budget deficit, but that annualized inflation will nevertheless rise by 2% over the following decade due to the additional aggregate demand from easier fiscal policy. In that case, the price level in Country A will end up being 20% higher than previously expected after a decade, implying that A’s currency would have to fall immediately by 20% (Chart 8 – left-hand side column). Chart 8Short- And Long-Run Moves In Currencies Under Various Inflation And Interest Rate Scenarios The reason Country A’s currency has to fall by 20% at once, rather than grinding lower by 2% per year for ten years, is that we are assuming that interest rates in the two countries remain equal. If Country A’s currency were to fall slowly, Country B’s bonds would earn a higher return in common-currency terms during the entire period when Country A’s exchange rate was trending lower. This would violate the second equilibrium condition. Thus, this framework implies that only unanticipated changes to policy can lead to discrete (i.e., step function) changes in exchange rates. Let us now consider a different scenario where the central bank in Country A, rather than accommodating easier fiscal policy, immediately moves to neutralize the stimulative impact of a larger budget deficit by hiking interest rates by two full percentage points. Since there is no net impact on aggregate demand, inflation expectations in Country A do not change.2 Country A’s exchange rate does change, however: it immediately appreciates by 20% (Chart 8 – middle column). This appreciation is necessary to engender the expectation of a subsequent two percentage point per year depreciation in A’s exchange rate. The ensuing slow depreciation in A’s currency offsets the additional two percentage points in interest that A’s bonds pay over B’s bonds. One can easily imagine intermediate cases. For example, suppose Country A’s central bank raises interest rates by only one percentage point, which results in A’s price level rising by 5% over the subsequent decade relative to B’s price level. As the right-hand side column of Chart 8 shows, A’s exchange rate would initially appreciate by 5%, but then depreciate by one percent every year for a decade, ultimately finishing 5% below where it started. An Added Wrinkle: Portfolio Balance Effects Before we apply this framework to the outlook for the US dollar, we need to discuss something that is central to Stephen Roach’s thesis, which is the role of portfolio balance effects. In the discussion above we said nothing about current account deficits, US indebtedness to the rest of the world, or the dollar’s reserve currency status. This is because we assumed that investors would be indifferent between holding Country A's and B’s bonds as long as they offered the same expected returns after accounting for projected exchange rate movements. In reality, financial assets are not perfectly substitutable. Changes in “portfolio balance” – the quantity and composition of assets available to the public – is likely to have an effect on returns. Thus, if Country A’s government issues more debt in order to finance a wider budget deficit, investors may demand a higher return to induce them to hold that additional debt. This extra return is likely to be larger if there is more uncertainty about the path of inflation. In the context of the first example discussed above, Country A’s exchange rate may have to fall by more than 20%. A weakening of Country A’s exchange rate would allow investors in B to purchase the same number of Country A bonds but at a lower cost when measured in B’s currency. Moreover, by undershooting its long-term fair value – and thus creating expectations of an appreciation in its currency – Country A can increase the appeal of its bonds. The expected appreciation of A’s exchange rate following a big depreciation effectively compensates investors with a risk premium for owning A’s bonds. This is why we phrased our second equilibrium condition in terms of “risk-adjusted” returns rather than simply expected returns. What All This Means For The Dollar Chart 9Rising Budget Deficits Do Not Automatically Translate Into A Weaker Dollar The key insight from our analysis is that the relationship between budget deficits and exchange rates is indeterminate. If the Fed adopts a hawkish stance in order to keep inflation from accelerating, like Paul Volcker’s Fed did in the early 1980s, the dollar could rise (Chart 9). In contrast, if the Fed keeps rates on hold in the face of rising budget deficits, the dollar is more likely to weaken. Arguably, this is what happened in the early 2000s following the Bush tax cuts. The downward pressure on the dollar would intensify if, as per our discussion of portfolio balance effects, investors started demanding a higher risk premium to hold US assets. Today, the Fed is effectively capping nominal bond yields through unlimited bond purchases and aggressive forward guidance committing to easy policy for years. Jay Powell has gone as far as to say that “we’re not even thinking about thinking about raising rates.” As such, the passage of a new US fiscal stimulus package would mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. Chart 10Labor Market Slack Will Keep Inflation In Check Chart 11Inflation Expectations Tend To Track Realized Inflation Could further dollar weakness morph into a disorderly dollar selloff which hurts, rather than helps, global equities and other risk assets? While such an outcome cannot be ruled out, it is a low-probability scenario for the moment. For one thing, the US output gap – the difference between what the economy can potentially produce and what it is producing now – is very large. Inflation is unlikely to rise significantly if there is still a fair amount of labor market slack (Chart 10). Historically, inflation expectations have tended to track actual inflation (Chart 11). If the latter remains contained for the next few years, so will the former. What about the possibility that bigger budget deficits will produce much larger current account deficits? It is certainly true that if private-sector savings did not change, a bigger budget deficit would reduce national savings, leading to a larger current account deficit. It is also true that US external liabilities now far exceed foreign assets, reflecting the fact that the US has run a current account deficit every year since 1982 (Chart 12). Chart 12Many Decades Of Current Account Deficits Have Led To A Negative Net International Investment Position For The US Fortunately, things are not quite as bleak for the dollar as they seem, at least for now. Despite a net international investment position of negative 56% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 13). This reflects the fact that US foreign liabilities are mainly comprised of low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 14). Chart 13The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 14A Breakdown Of US Assets And Liabilities Chart 15Government Transfers Primarily Boosted Personal Savings This Year With Little External Spillovers So Far Moreover, to the extent that the US economy is operating below its potential, fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will reduce the need for the US to source capital from abroad. If the government transfers money to households and they save it, private-sector savings will rise by the same amount that government savings fall. If households spend the money, GDP and national income will rise. The resulting increase in income will boost savings.3 This is precisely what has happened this year: The fiscal deficit has soared, private-sector savings have exploded, and the trade balance has basically gone sideways (Chart 15). Granted, to the extent that some of the spending will be directed towards imports, the current account deficit will widen over the coming months. However, stronger growth will also increase corporate profitability. This could attenuate any capital outflows from the US, thus preventing the dollar from falling as much as it otherwise would have. Investment Conclusions Chart 16Global Equities Tend To Outperform Bonds When Global Growth Is Strengthening And The Dollar Is Weakening The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Global equities have generally outperformed bonds when global growth is strengthening, and the dollar is weakening (Chart 16). Non-US stocks, cyclical stocks, value stocks, and small caps all tend to fare best in a weaker dollar environment (Chart 17). These stocks are also quite cheap compared to their counterparts: US stocks, defensive stocks, growth stocks, and large caps (Chart 18). Chart 17ANon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… Chart 17BNon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… Chart 18… And They Are Cheap To Boot Looking further out, the outlook for equities is less rosy. Stagflationary pressures could emerge in 2023 or thereabouts as unemployment falls to pre-pandemic levels and supply-side constraints begin to bite. If that were to happen, profit margins would come under pressure, sending equities lower. It is not clear how the US dollar would perform in that environment. On the one hand, a risk-off environment would tend to favor the greenback. On the other hand, if the Fed is perceived as being too slow to tame inflation, the dollar could sink. Of course, much depends on what is happening in other economies. Exchange rates are relative prices. If inflation rises everywhere, the big winners from higher inflation would not be other fiat currencies, but hard currencies such as gold. That is why we continue to recommend that investors stay long the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Current MacroQuant Model Scores Footnotes 1 Rudiger Dornbusch, “Expectations And Exchange Rate Dynamics,” The Journal of Political Economy, (84:6), December 1976. return to text 2 We are assuming that the central bank in Country A takes into account the impact that a stronger currency will have on aggregate demand when choosing the appropriate level of interest rates that neutralizes the effect of easier fiscal policy. return to text 3 For example, suppose households spend 75 cents of every dollar the government transfers to them exclusively on domestically-produced goods and services. If a government transfers $100 to households, $25 will be saved while the remaining $75 will be spent, thereby generating an additional $75 in GDP and income for the economy. Of the additional $75 in income, 25% ($18.75) will be saved while 75% ($56.25) will be spent. It is straightforward to show that if this process continues indefinitely, a total of 75+0.75*75+0.75^2*75+0.75^3*75+…=75/(1-0.75)=$300 in GDP and income will be generated. This means that private-sector savings will increase by 25+0.25*300=$100, which is exactly equal to the decline in government savings. Private-sector savings would rise by less than $100 if a portion of the spending was directed to imports. For instance, if households spent 15 cents of every dollar of income on imports, GDP would rise by 60+0.60*60+0.60^2*60+0.60^3*60+…=60/(1/1-0.60)=$150, while private savings would rise by 25+0.25*150=$62.50. return to text
Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts. There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates. Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Nominal Yields: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yields: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. US Economy: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Feature Chart 1Reflation Pushes Real Yields Lower Market movements during the past couple of months are consistent with an environment of economic reflation. Equities and commodity prices are up, the US dollar is down, spread product has outperformed Treasuries and TIPS breakeven inflation rates have widened. This “reflation trade” is the result of global economic recovery and highly accommodative Fed policy, the latter being particularly important. In fact, Fed policy has been so accommodative that bonds are the one asset class that has so far bucked the broader reflationary trend. Nominal Treasury yields dipped during the past few weeks, as rising inflation expectations were more than offset by plunging real yields (Chart 1). Our base case expectation is that, broadly speaking, the reflation trade will continue. Global economic growth will improve during the next 6-12 months and Fed policy will remain highly accommodative. In this week’s report we consider how to position for that outcome in US rates markets. In the process, we provide trade recommendations for the nominal, real and inflation compensation curves. We also consider the main risk to our reflationary view: The possibility that further US fiscal stimulus is too little or arrives too late. Positioning For Reflation Chart 2More Downside In Short-Maturity Real Yields Back in April, we explained how the Fed’s zero-lower-bound interest rate policy can lead to unusual movements in bond markets, particularly in how real bond yields respond to broader market trends.1 The importance of the zero lower bound is easily seen through the lens of the Fisher Equation – the equation that connects nominal yields, real yields and inflation expectations. Real Yield = Nominal Yield – Inflation Expectations If the Fed is expected to hold the nominal short rate steady for a long period of time, then nominal bond yields won’t move around very much in response to the economy. Necessarily, this means that increases in inflation expectations must be matched by falling real yields. Chart 1 shows how this has played out for 10-year yields, but the dynamic is even more pronounced at the short-end of the curve where the Fed has greater control over nominal rate expectations (Chart 2). With these relationships in mind, we consider the outlooks for the nominal, inflation compensation and real yield curves. Nominal Treasury Curve Chart 3Fed Guidance Has Crushed Nominal Rate Vol As is alluded to above, fed funds rate expectations drive nominal Treasury yields. Treasury yields rise when the market revises its rate expectations up and fall when the market revises its expectations down. But what happens when the Fed signals that the funds rate will stay pinned at its current level, even as inflationary pressures mount? What happens is that nominal bond yields become increasingly insensitive to fluctuations in economic data and rate volatility plunges (Chart 3). Not surprisingly, this decline in rate volatility has been more pronounced at the front-end of the curve than at the long-end (Chart 3, bottom panel). This is because the Fed’s rate guidance exerts more influence over short maturities. The market might be very confident that the fed funds rate will stay at its current level for the next year or two, but it will be less confident about rate expectations five or ten years down the road. The conclusion we draw is that the Fed’s dovish rate guidance will prevent a large increase in nominal bond yields, even as the reflation trade rolls on. But at some point, rising inflation expectations will cause the market to price-in policy firming at the long-end of the curve and long-maturity nominal Treasury yields will move somewhat higher. Historically, nominal bond yields usually move in the same direction as TIPS breakeven inflation rates (Chart 4). Chart 4Nominal Yields And Inflation Expectations Are Positively Correlated While this base case outlook calls for flat-to-slightly higher Treasury yields, we recommend keeping portfolio duration close to benchmark on a 6-12 month investment horizon. The reason for this caution is that significant downside risks to our base case economic scenario remain (see section “Avoiding Deflation” below). Chart 5Bullets Trade Expensive When Rates Are Pinned At Zero Instead, we recommend positioning for the continuation of the reflation trade via duration-neutral yield curve steepeners. The nominal yield curve will respond to global economic recovery by steepening because the market will price-in eventual policy tightening at the long-end of the curve before it prices-in near-term policy tightening at the front-end of the curve. Specifically, we suggest buying the 5-year bullet and shorting a duration-neutral barbell consisting of the 2-year and 10-year notes. This trade is designed to profit from steepening of the 2/10 yield curve.2 The one problem with our proposed trade is that it is not cheap. The 5-year bullet yield is below the 2/10 barbell yield and the 5-year bullet trades as expensive on our yield curve model (Chart 5). However, we note that the 5-year looked much more expensive at the height of the last zero-lower-bound episode in 2012. In today’s similar environment, we anticipate a return to similar valuation levels. Bottom Line: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation Curve Chart 6Adaptive Expectations Model Almost by definition, the continuation of the reflation trade means that the cost of inflation compensation will rise (i.e. TIPS breakeven inflation rates will move higher), and we remain positioned for that outcome. However, at least according to our Adaptive Expectations Model, the inflation component of bond yields could have a more difficult time rising going forward. Our model, which is based on several different measures of realized inflation, shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value (Chart 6). In other words, further upside from here is contingent upon rising inflation. Fortunately, rising inflation seems likely during the next few months. Month-over-month headline CPI bottomed in April (Chart 7), the oil price is trending up (Chart 7, panel 2) and core inflation has undershot relative to the trimmed mean (Chart 7, panel 3). All of this suggests that our model’s fair value will move higher during the next few months. Chart 7Inflation Has Bottomed But beyond the near-term snapback that we anticipate, a wide output gap in the United States will prevent inflation from entering a sustainable uptrend as we head into 2021. After all, our Pipeline Inflation Indicator remains deep in deflationary territory (Chart 7, bottom panel). At some point near the end of this year, we anticipate getting an opportunity to move tactically underweight TIPS versus nominal Treasuries, once breakevens start to look expensive on our model. Our Adaptive Expectations Model shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value. A higher conviction long-run trade relates to the slope of the inflation curve. At present, the 10-year CPI swap rate remains somewhat above the 2-year rate, but we eventually expect this slope to invert (Chart 8). With the Fed explicitly targeting a temporary overshoot of its 2% inflation target, it would make sense for the cost of short-maturity inflation protection to trade above the cost of long-maturity inflation protection. This would mark a significant break from historical trends, but this is also true of the Fed’s new policy approach. Chart 8Inflation Curve Will Invert Bottom Line: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yield Curve Chart 9Buy Real Yield Curve Steepeners At the beginning of this report we noted that the combination of stable nominal rate expectations and rising inflation expectations has led to a steep decline in real Treasury yields. This decline has been more severe at the short-end of the curve, which has resulted in real yield curve steepening (Chart 9). At the long-end of the curve, the outlook for the level of real yields is highly uncertain, even under the assumption that the reflation trade continues. If 10-year nominal rate expectations hold steady, then continued reflation will lead to a further decline in the 10-year real yield. However, as discussed above, long-dated nominal rate expectations will eventually follow inflation expectations higher. If that adjustment to long-dated rate expectations outpaces the increase in expected inflation compensation, then the 10-year real yield will move up as well. The outlook for the short-end of the curve is more certain. Two-year nominal rate expectations are unlikely to budge anytime soon. This means that the continuation of the reflation trade will send the cost of 2-year inflation protection higher and the 2-year real yield lower. For this reason, we would rather take a position in real yield curve steepeners than an outright position on the level of real yields. In fact, as long as the reflation trade continues, the real yield curve should steepen whether the absolute level of real yields is rising or falling. It is only in a renewed deflation scare where we would expect the real yield curve to flatten, as occurred back in March. As long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Bottom Line: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Avoiding Deflation The first part of this report talked about how to position in rates markets assuming that the global economic recovery remains on track and that the so-called reflation trade continues. While this is our base case scenario, it is by no means a certainty. In fact, this view is contingent upon continued US fiscal stimulus that is sufficient to sustain household income and prevent a snowballing of foreclosures and bankruptcies. March’s CARES act did a more-than-admirable job supporting household income. In fact, disposable household income rose 7.2% in the four month period between March and June compared to the four months that preceded the COVID recession (Chart 10). This is a far greater increase than what was seen in the first four months of the 2008 recession (dashed line in Chart 10, panel 2), despite the fact that the hit to wage compensation has been worse (dashed line in Chart 10, bottom panel). Chart 11A confirms that, without the CARES act, the hit to disposable income would have been substantial. Chart 10Income Well Supported... So Far Chart 11ADisposable Personal Income Growth And Its Drivers I The problem is that the main income supporting provisions of the CARES act have either been paid out or have expired. Chart 11B shows the impact on disposable income of the CARES act’s different provisions. The two most important were: The Economic Impact Payments: The one-time $1200 stimulus checks. The Pandemic Unemployment Compensation Payments: The extra $600 per week that was added to unemployment benefits. Chart 11BDisposable Personal Income Growth And Its Drivers II The Economic Impact Payments have all been delivered, and the Pandemic Unemployment Compensation Payments expired at the end of July. Based on the information that has been released about the ongoing negotiations over a follow-up stimulus bill, we expect that a compromise deal will be large enough to keep disposable income at or above pre-recession levels.3 However, a compromise is proving difficult. Congress’ foot dragging prompted President Trump to announce several executive orders of questionable legality in an attempt to deliver some stimulus. However, even if the executive orders are followed, the boost to household income will be meager without another bill. The President’s executive order to extend the extra unemployment benefits appropriates only $44 billion from the Disaster Relief Fund and asks states to contribute the rest. Many states will be unable to contribute anything, and an extra $44 billion amounts to only 8% of the income support provided by the CARES act. State & local government aid must be addressed in the new stimulus bill. The other urgent area that must be addressed in a follow-up stimulus bill is aid for state & local governments. State & local government spending fell 5.6% (annualized) in the second quarter, as governments have been forced to impose harsh austerity in the face of collapsing tax revenues (Chart 12). This is one area where the Democrats and Republicans are still far apart. The Center on Budget and Policy Priorities estimates that states need $555 billion to close COVID-related budget shortfalls.4 The Democrats’ initial proposal contained $1.13 trillion for states, the Republicans’ initial offer left out state & local government aid altogether. Chart 12State & Local Governments Need A Bailout Bottom Line: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Based on the numbers that have been floated, that deal will contain sufficient income support to keep households afloat and the recovery on track. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 To understand why this trade profits in an environment of yield curve steepening please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 In their initial proposals, House Democrats offered $435 billion in Economic Impact Payments and $437 billion for expanded unemployment benefits. The Senate Republicans offered $300 billion for Economic Impact Payments and $110 billion for expanded unemployment benefits. For context, the CARES act authorized $293 billion for Economic Impact Payments and $268 billion for expanded unemployment benefits. For more details on the ongoing budget negotiations please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War”, dated July 31, 2020, available at gps.bcaresearch.com 4 https://www.cbpp.org/research/state-budget-and-tax/states-continue-to-face-large-shortfalls-due-to-covid-19-effects Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Ultimately the US Congress will pass a major stimulus bill, but short-term risks to the equity rally are elevated. President Trump’s executive actions are not sufficient stimulus in the absence of an act of Congress. Trump’s opinion polling is starting to recover. A sustainable comeback requires Trump to sign a bill, the stock market to avoid a correction, COVID-19 new cases to continue subsiding, and crime to rise such that “law and order” resonates with voters. Depending on the data, we will upgrade Trump’s odds of victory from 35%. A major Trump comeback would increase global economic policy uncertainty relative to the United States. This would support the USD and US equity outperformance relative to global in the near term, though the opposite is still likely over the long term. Feature Over the weekend President Trump resorted to executive orders to bypass the gridlock in Congress over the next round of fiscal support for the pandemic-stricken economy. He issued four decrees that would provide $400 per week in new federal unemployment benefits; defer the 6.2% payroll tax on US workers making less than $100,000 through December 31; assist renters and homeowners with monthly payments; and delay student debt repayments. These actions are politically popular and Democrats will have trouble criticizing them. But they are not ultimately sufficient for the US economy or stock market. They should be seen as part of a “stimulus hiccup” that fails to deliver the equity market from the elevated risk of a correction in the very near term. First, these measures are leaner than any compromise bill that would come from Capitol Hill. They will also be difficult to implement as US states are required to provide 25% of the unemployment benefits while individual companies are needed to manage the payroll tax. Uncertainty will be high and compliance low, especially initially. Second, federal courts will add to uncertainty by raising legal questions about the president’s decrees, probably issuing injunctions. The president is partly redirecting funds already appropriated, which can be gotten away with (especially during emergencies and on a temporary basis), but he is flirting with making unilateral appropriations, which is unconstitutional. Legal questions will make it harder for states and firms to know whether and how to implement the orders, vitiating their effect. Thus if the president’s actions are not quickly superseded by a full relief bill from Congress, the market will be disappointed, along with business and consumer confidence and balance sheets. Fiscal policy is of utmost importance to financial markets because the major central banks are limited due to the zero lower bound. Any premature interruption in fiscal support could cause markets to go into a tailspin on the fear that household and business finances and confidence will relapse, with longer-term damage. Chart 1Volatility Rises Ahead Of Elections Volatility has not picked up much because the pandemic numbers are improving (see below) and these executive actions offer a bridge to a full stimulus bill later (Chart 1). But that means further delays will cause bigger swings – especially if Congress does not get a deal by the end of this week. With election risks and geopolitical risks also escalating, August could easily whipsaw bullish equity investors who have grown complacent with this year’s rapid rebound. Ultimately, we maintain that Congress will pass a bill. GOP senators will succumb to political pressure. Both Trump and the Republicans are looking extremely vulnerable in public opinion polling. A failure on pandemic relief would likely be the final straw for voters. Concessions to House Democrats will produce a bill of around $2.5 trillion for President Trump to sign (Table 1). Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) Chart 2Republicans Will Forgive Senate Largesse If Re-Elected The opposing risk – that Republicans will lose votes for being fiscally profligate – is a far lower bar for them to cross. Republicans worry less about Big Government when their own party runs the government (Chart 2). Assuming GOP senators get with the program and a bill is passed, markets will turn to the 2020 election battle. This election is more significant than usual because it pits an anti-establishment candidate against a political establishment that is circling the wagons, thus portending structural consequences for the US economy, particularly on trade and immigration. President Trump is the underdog because of the pandemic and recession. High unemployment is deadly for sitting presidents. Voters clearly believe he has mishandled the pandemic; they also believe he has mishandled race relations amid an explosion of racially charged social unrest. But these factors are now baked in the cake. There are three factors that can sustain Trump’s comeback in the opinion polls: Stimulus passes: Passage of a new stimulus bill will buttress the households, businesses, and the stock market. By issuing executive orders, Trump has shown he has no patience for Congress’s dithering. This will resonate with voters, but only so far. A full stimulus bill needs to be signed and disbursed to sustain his rebound in popular opinion. COVID-19 abates: COVID-19 hospitalizations and new cases are rolling over, giving society (and markets) a reason to be optimistic (Chart 3). As long as stimulus is passed, people can continue distancing without reversing the economic recovery. If the virus abates, Trump’s net approval rating will also improve. “Law and order” resonates: Trump has taken a hard line on crime, violence, and vandalism amid this summer’s social unrest. If crime rises in the suburbs in swing states, then his message may resonate with critical voters. Alternately he could gain traction for tough foreign policy on China (as long as stocks do not collapse) or Iran. Chart 3COVID-19 Hospitalizations And New Cases Rolling Over Chart 4Trump’s Comeback Begins – Is It Sustainable? Trump’s polling head-to-head against his rival, former Vice President Joe Biden, suggests that he has hit the floor in the swing states but not national polling – and it is swing states that determine the Electoral College outcome (Chart 4). If these three trends fall together, Trump’s comeback in opinion polls will be sustainable and we would need to upgrade his odds of victory, which we set at 35% in March. Global policy uncertainty would rise relative to the United States, as Trump is disruptive on the global scene. The US dollar could bounce, or at least stay flat, as near-term geopolitical risk would vie with surging debt monetization, which will weaken the dollar over the long run. US equity performance relative to global stocks would get a boost due to higher odds of more significant protectionism and trade conflict in 2021-24. By contrast, if Congress fails on stimulus, the stock market corrects, COVID reaccelerates with the school year, and the “law and order” theme flops, then Trump’s polling will see a dead-cat bounce. US policy uncertainty would rise relative to global, as Biden and the Democrats would raise regulation and taxes at home yet act with greater predictability abroad (Chart 5). Chart 5A Trump Comeback Would Boost US Equity Outperformance Until the three trends above confirm the basis for Trump to have a sustainable comeback, we maintain that his odds of victory are 35%. Our quantitative model reveals upside risk by indicating he has a 42% chance (Chart 6). Chart 6Geopolitical Strategy Quant Model: Trump Has 42% Chance Of Victory Bottom Line: Investors should be prepared for a risk-off episode in the near term in case Congress fails to compromise on a major new fiscal stimulus. Assuming they agree, President Trump will have a comeback in opinion polls that could be sustainable and justify an upgrade of his election chances. That in turn would raise the risk of significant escalation in the trade war for China (and Europe) and eliminate the risk of higher taxes and regulation in the United States in 2021. Investors who are aggressively short the dollar, or heavily invested into cyclical stocks and regions, would get blindsided in the short run by such a turn of events, even though this positioning makes sense over the long run. After all, over the long run for the dollar, the whole dynamic outlined in this report underscores that austerity is dead: if Trump wins he was rewarded for using populist spending by executive fiat; if Democrats win then their mega-spending proposition paid off. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Markets have shrugged off the rise in COVID-19 cases in the US and new clusters in other places such as Spain, Hong Kong, Melbourne, and Tokyo (Chart 1). The MSCI All-Country World Index is now only 4% off its all-time high in February. We don’t see the markets ignoring reality for much longer. Economic activity remains very subdued (Chart 2), which will eventually cause a significant rise in bankruptcies and problems for banks. Nevertheless, the unprecedented monetary and fiscal stimulus will be increased further in coming weeks, which should prevent a big shift towards pessimism for a while. The crunch time will come in the northern-hemisphere winter, when COVID cases in North America and Europe are likely to rise sharply again. Risk assets at their current levels are not pricing in those risks. Recommended Allocation Chart 1COVID Cases Are Still On The Rise Chart 2Activity Remains Subdued Markets are driven by the second derivative of growth. It is not surprising, then, that equities began to rally in March, exactly when economic data stopped deteriorating, even though it remained atrocious (Chart 3). Real interest rates have also continued to fall, even as risk assets rallied; this further fueled the rally, since the theoretical value of equities rises as the rate at which they are discounted falls (Chart 4). Chart 3Data Stopped Deteriorating In March Chart 4Real Interest Rates Have Continued To Fall But the question now is: Can the data continue to improve? PMIs will fall back towards 50, and economic releases are unlikely to surprise so strongly on the upside. In the US, as a result of the rise in COVID-19 cases and renewed (albeit mostly moderate) government restrictions on activity, consumer confidence has started to weaken again and initial unemployment claims to pick up (Charts 5 and 6). Even though the Fed will remain ultra-dovish, real rates will not fall much further from their current level, which is the lowest since TIPS started trading in the late 1990s. Chart 5Consumer Confidence Is Weakening Again Chart 6The Jobs Market Has Stopped Improving Chart 7Will Money Supply Growth Peak? Money supply growth has grown rapidly, as a result of the increase in central-bank balance-sheets and the rush of companies to borrow to shore up their cash positions (Chart 7). The increase in excess liquidity has also been a force behind the rise in risk assets. But money supply growth is likely to slow from now. At least partly offsetting these risks will be further fiscal stimulus. BCA Research’s Geopolitical strategists see Congress approving a big new package of around $2.5 trillion, mainly because of widespread popular support for an extension of more generous unemployment benefits (Table 1). Agreement should come before the scheduled recess on August 10 (if it doesn’t, this would trigger a market selloff). The recent agreement between European Union leaders on a EUR750 billion fiscal package was a major breakthrough, since it represented joint borrowing backed by the rich northern European countries to provide transfers to the poorer periphery. Table 1There Is Much Public Support For Fiscal Stimulus Further upside may come as the many investors who have missed the rally since March capitulate and buy risk assets. Investor sentiment is currently unusually polarized. Speculative individuals and hedge funds are very bullish (Chart 8). But more conservative pension funds, wealth managers, and individual investors, mostly remain cautious, as evidenced by the AAII weekly survey, in which many more investors say they expect the stock market to fall over the next six months than to rise (Chart 9). Cash levels remain high by historical standards (Chart 10). Although only a minority of investors turned positive in March, a recent academic study demonstrated how hedge funds and small active institutions have a disproportionate influence on price movements (Chart 11). A downside risk, then, would be if these investors decided to take profits or turned more bearish. Chart 8Hedge Funds Are Bullish... Chart 9...But Retail Investors Very Cautious Chart 10Cash Holdings Remain Elevated Chart 11Some Smaller Investors Have A Big Impact We have argued, since the pandemic began, that investors should not take high-conviction bets in such an uncertain environment. They should, rather, design portfolios which are robust under various scenarios. After the 43% rise in global equities since March, we cannot recommend an above-benchmark weighting, since downside risks are not priced in. We remain neutral on global equities. However, fixed-income instruments look even more unattractive at the current low level of rates; we remain underweight. We recommend hedging via a large overweight in cash, which leaves dry powder for when a better buying opportunity arises. Currencies: A key (as always) to the macro view is what happens to the US dollar. Many of the drivers of the dollar – interest-rate differentials, valuation, momentum, and relative money-supply growth – point to it weakening further (Chart 12). The trade-weighted dollar is already off 9% from its March peak. We turned bearish on the USD in our Quarterly published at the beginning of July. It is too early, however, to declare that the dollar bull market, which began in 2012, is definitely over. Chart 12Dollar Indicators Are Bearish... Chart 13…But Short USD Is Now A Consensus A new downturn in the global economy would push the dollar back up again, since it is a safe-haven currency. Shorting the dollar, especially against the euro, is now a consensus position, and so a near-term reversal is quite likely (Chart 13). But, over the next 12-18 months, a move above 1.22 for the euro and towards 100 for the yen is possible. We will continue to analyze whether the dollar could be entering a bear market, since this would necessarily make us more structurally positive on commodities and emerging markets. Equities: A pickup in global growth and a weakening US dollar might prove positive for cyclicals and value stocks in the long run, which would cause European and EM equities to outperform. Given the current uncertainty, however, we cannot recommend that stance and therefore continue to prefer “growth defensives” such as Health Care and Technology, which implies an overweight on the overall US market. Valuations in the Health Care sector remain attractive (Chart 14). Companies in the (broadly defined) Tech sector are beneficiaries of the pandemic, generally have robust balance-sheets, and should continue to see strong earnings growth for some years. And, while Technology is clearly expensive, valuations are still nowhere as excessive as in 2000 (Chart 15). For Tech to crash would require either that it go ex-growth, or that there is significant regulatory action. Chart 14Health Care Still Attractively Valued Chart 15Tech Still Way Below Bubble Levels Chart 16Europe No Longer So Dominated By Financials Neither of these seems likely for now. Euro zone equities are less dominated than they were by Financials, but remain more cyclical than the US, with very few internet-related names (Chart 16). Fixed Income: Central banks will remain very dovish and, as Fed chair Jerome Powell has emphasized, are not even thinking about thinking about tightening policy. This suggests that nominal rates will rise only moderately, even if growth continues to pick up. The Fed still has plenty of room to ease further if needed, since the programs it rolled out in March have barely been taken up yet (Table 2). We thus recommend a neutral position on duration. We find TIPS attractive as a hedge against an eventual spike in inflation. The 10-year breakeven inflation rate implied in TIPS remains around 100 basis points below being compatible with the Fed achieving its 2% PCE inflation target in the long run (Chart 17). The announcement in September of the results of the Fed’s 18-month review of its policy framework, which is likely to intensify its efforts to achieve the inflation target, could push breakevens up a bit further. In credit, we continue to recommend buying whatever central banks are buying, mostly investment-grade corporate bonds and the top end of the US junk bond market. Though spreads have fallen a long way, they are still well above end-2019 levels, and look attractive in a world of such low government bond yields (Chart 18). Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Chart 17TIPS Still Pricing Low Inflation For A Decade Chart 18Credit Spreads Could Fall Further Commodities: The weakening US dollar and continued expansion of Chinese stimulus (Chart 19) should be positive for industrial metals prices over the next six to nine months. Oil prices also have some further upside, since the OPEC 2.0 agreement to restrict supply is being adhered to, and demand will gradually pick up (although air travel will remain depressed, more commuters are using their cars as they avoid public transport). BCA Research’s Energy Service forecasts Brent crude to average $44 in the second half of this year, and $65 in 2021 (up from the current $43). Gold has already run up a lot and is now close to a record high price in real terms, with sentiment very optimistic (Chart 20). Chart 19China Stimulus Positive For Metals Nonetheless, in an environment of very low real rates, it represents a good hedge against extreme tail risks, and therefore we continue to recommend a moderate position as an insurance. Chart 20Gold Looking Rather Toppish Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Garry Evans, Chief Global Asset Allocation Strategist. Garry will be discussing the social and industrial changes that will remain in place even after the COVID-19 pandemic is over, and how investors should tilt their portfolios to take advantage of them. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The number of coronavirus cases in the US appears to have peaked. Negotiations to avert a fiscal cliff continue in Washington. While we expect a deal to be reached, markets could tread nervously until this happens. The US dollar will weaken further over the next 12 months. Narrowing interest rate differentials, a revival in global growth, deteriorating momentum, and pricey valuations all bode poorly for the greenback. Global equities in general, and non-US stocks in particular, tend to fare well in a weak dollar environment. Small cap and value stocks usually outperform when the dollar weakens. Bank shares should start to do better as yield curves steepen and faster economic growth reduces concerns over non-performing loans. US Virus Wave Cresting, But Fiscal Risks Intensifying Chart 1US: Number Of New Cases Seems To Be Peaking Last week, we argued that the two biggest near-term threats to stocks and other risky assets were the rising number of coronavirus cases in parts of the US and the looming fiscal cliff.1 Since then, the news on the virus has been broadly positive, while developments on the fiscal front have been mixed. Chart 1 shows that the number of new cases seems to have peaked in the US. In Texas, Florida, California, and Arizona, the share of doctor visits linked to suspected Covid infections is trending lower. This metric leads diagnoses by about one-to-two weeks (Chart 2). Chart 2Doctor Visits, Which Lead Diagnoses, Are Trending Lower Over half the US population lives in states that have either suspended or reversed reopening plans (Chart 3). Assuming the number of infections keeps falling and fiscal policy is not unduly tightened, household spending and employment growth – which appear to have stalled out in the second half of July – should begin to pick up. Chart 3Not So Fast Unfortunately, the assumption that fiscal policy will remain stimulative looks somewhat shaky. Expanded unemployment benefits for 30 million Americans, consisting mainly of an additional $600 per week for unemployed workers, are set to expire at the end of July. Congressional Republicans have suggested trimming benefits to $200 per week. However, even that would represent a fiscal tightening of nearly 3% of GDP. A Question Of Incentives The Republican position is understandable, given that two-thirds of unemployed workers are currently receiving more in unemployment benefits than they earned while working. Thus, some scaling back of benefits is not only inevitable, but desirable. The question is one of timing. While job openings have risen from their lows, they are still 23% below where they were at the start of the year. According to the NFIB survey, the share of small businesses reporting difficulty in finding qualified workers has also fallen from year-ago levels. When the binding constraint on employment is a shortage of jobs rather than a shortage of workers, higher unemployment benefits will likely boost hiring. This is because increased benefits will increase spending on goods and services across the economy, thus augmenting the demand for labor. Debt, Gold, And The Dollar Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Does the inevitable increase in government debt due to ongoing fiscal stimulus portend disaster down the road? According to many commentators, the recent drop in the dollar and the surge in gold prices is surely telling us that it does. While it is a compelling story, it is mainly false. The yield on the 30-year Treasury bond currently stands at 1.20%, down from 1.5% in mid-June and 2.33% at the start of the year. Bondholders may be many things, but masochistic is not one of them. If they really thought a fiscal crisis was around the corner, yields would be a lot higher. So why is the dollar falling and gold rallying? The answer is inflation expectations have risen off very low levels, which has pushed down real yields. Gold prices are almost perfectly correlated with real interest rates (Chart 4). The Real Reason The Dollar Has Fallen Going into this year, US real yields had a lot more room to decline than rates abroad. For example, at the start of 2019, US real 2-year yields were 221 bps above comparable euro area yields. Today, US real rates are 35 bps lower – a swing of 256 bps. Yield differentials have narrowed against other economies as well, which has pushed down the value of the dollar (Chart 5). In addition, relative growth dynamics have hurt the greenback. The US economy tends to be less cyclical than most of its trading partners. While the US benefits from faster global growth, the rest of the world benefits even more. This causes capital to flow from the US to other countries, leading to a weaker dollar (Chart 6). Chart 5The Greenback Has Been Losing Interest Rate Support Chart 6The Dollar Usually Weakens When Global Growth Accelerates Chart 7The Dollar And Cycles BCA Research’s Foreign Exchange Strategist, Chester Ntonifor, has stressed that the dollar typically fares worst in the initial stages of business cycle recoveries (Chart 7). That is the stage we are in today. Indeed, the gap in growth between the US and the rest of the world is likely to be larger than usual over the next few quarters because the pandemic has hit the US harder than most other developed economies. Momentum is also working against the dollar. Being a contrarian is usually a smart investment strategy. That is not the case when it comes to trading the dollar. With the dollar, you want to follow the herd. This is because the dollar is a high momentum currency (Chart 8). A simple trading rule that buys the dollar when it is trading above its 50-day or 200-day moving average, and sells the dollar when it is trading below its respective moving averages, has historically made a lot of money. Likewise, the dollar performs best prospectively when sentiment is bullish and improving (Chart 9). Currently, the dollar is trading below its various moving averages. Sentiment is also poor and deteriorating (Chart 10). Chart 8USD Is A High Momentum Currency Chart 9Trading The Dollar: The Trend Is Your Friend Chart 10The Dollar Has Started Breaking Down Chart 11The Dollar Is Still Fairly Expensive If the dollar were cheap, all the factors discussed above could be overlooked. But the dollar is not cheap. It is still pricey based on purchasing power parity measures which compare the common-currency cost of identical consumption bundles from one country to the next (Chart 11). A Weaker Dollar is Bullish For Stocks, Especially Non-US Stocks Global equities in general, and non-US stocks in particular, tend to perform well when the dollar is weakening (Chart 12). Chart 12A Weaker Dollar Should Help Global Equities Chart 13Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclical sectors such as industrials, energy, and materials normally outperform defensives in a weak dollar environment (Chart 13). Relative profit growth in these sectors tends to rise when the dollar depreciates (Chart 14). To the extent that cyclicals are overrepresented in stock market indices outside the US, this gives non-US equities a leg up. Chart 14Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates EM Is The Big Winner From Dollar Weakness A weaker dollar is particularly beneficial to emerging markets. Commodity prices usually rise when the dollar drops (Chart 15). Rising resource prices are good news for many emerging markets. EM debt dynamics also tend to improve when the dollar weakens. EM external debt has grown in recent years (Chart 16). About 80% of EM foreign currency denominated debt is in dollars. A falling dollar reduces the local-currency value of US dollar-denominated liabilities, thus strengthening the balance sheets of many EM companies and governments. Emerging markets with large current account deficits and significant dollar liabilities such as Brazil, Indonesia, Turkey, and Mexico will outperform EMs that generally run current account surpluses and have little in the way of foreign-currency debt. Chart 15Commodity Prices Usually Rise When The Dollar Falls Chart 16EM External Debt Has Grown In Recent Years The Federal Reserve today is trying to engineer an easing in US financial conditions. A weaker dollar is facilitating that goal. Historically, EM stocks have been almost perfectly inversely correlated with US financial conditions (Chart 17). Chart 17EM Equities Benefit From Easier US Financial Conditions What About DM? The impact of a weaker dollar on the stock markets of developed economies is more nuanced. Consider the euro area, for example. On the one hand, a stronger euro hurts the euro area economy, which can ultimately push down domestic profits. A stronger EUR/USD also reduces the profits of European companies with operations in the US when those profits are converted back into euros. That can also hurt European stocks. On the other hand, the overall reflationary effect of a weaker dollar on global growth tends to push up profits. In practice, the latter effect usually dominates the former. Thus, euro area stocks, just like stocks in most other markets, generally outperform the US when the dollar is weakening (Chart 18). Chart 18ANon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Chart 18BNon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Small Caps And Value Stocks Tend To Outperform When The Dollar Weakens Even though companies in the small cap Russell 2000 index generate less of their sales from abroad than those in the S&P 500, small caps still tend to outperform large caps in weak dollar environments (Chart 19). This is partly because smaller companies are more cyclical in nature. It is also because the US dollar performs best in a risk-off setting when investors are pouring money into the safe-haven Treasury markets. In contrast, small caps excel in a risk-on environment. Value stocks tend to outperform growth stocks in a weaker dollar environment (Chart 20). Like small caps, cyclical equity sectors are overrepresented in value indices. Financials also tend to punch above their weight in value indices. Chart 19Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Chart 20...The Same Goes For Value Stocks Small caps and value stocks outperformed between 2000 and 2008, a time when the US dollar was generally weakening. That period saw both a commodity boom and a wave of debt-fueled housing booms. The former lifted commodity prices, while the latter buoyed financials. Commodity prices should rise over the next 12 months thanks to a rebound in global growth and copious Chinese stimulus. Chart 21 shows that the Chinese credit impulse is on track to reach the highest levels since the Global Financial Crisis, while the fiscal deficit will probably hit a record 8% of GDP. The Outlook For Financial Stocks Gauging the outlook for financials is trickier. Credit growth has slowed sharply since the Global Financial Crisis, which has weighed on bank profits. The structural decline in bond yields has also been toxic for bank shares (Chart 22). Lower bond yields tend to translate into flatter yield curves, which can depress net interest margins. Chart 21China Has Opened The Spigots Chart 22The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks A falling dollar has historically been associated with higher bond yields (Chart 23). As global growth recovers over the next 12 months, bond yields will edge higher. That said, central bank bond purchases, coupled with aggressive forward guidance, will keep bond yields from rising as much as they normally would. And even if nominal yields do rise, inflation expectations will rise even more, implying that real yields will fall further. Falling real yields tend to benefit growth stocks more than they benefit value stocks. Chart 23Bond Yields Tend To Rise When The Dollar Weakens Still, even a modest steepening of the yield curve will be good for bank earnings. A recovery in economic activity should also dampen concerns about a spike in bad loans. Credit spreads normally fall when economic growth is improving and the dollar is weakening (Chart 24). Banks have significantly increased provisions since the start of the year, which has depressed reported earnings. If some of those provisions are reversed, profits will jump. Chart 24Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Chart 25Bank And Value Stocks Are Quite Cheap Moreover, bank stocks in particular, and value stocks in general, are extremely cheap by historic standards (Chart 25). Thus, while the case for favoring value over growth is not as clear-cut as it could be, it is strong enough that long term-oriented investors should consider moving capital from high-flying tech stocks to unloved value stocks. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Will Bond Yields Ever Go Up?” dated July 24, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
BCA Research's Global Investment Strategy service believes that the ample public support for fiscal stimulus will force the hand of Senate Republicans. Investors have to grapple with uncertainty over whether fiscal policy will remain sufficiently…