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Highlights President Trump’s final actions and the US fiscal impasse pose non-trivial risks to the rally. Biden’s foreign policy cabinet picks have limited impact but are mildly positive for now. Biden’s multilateralism will eventually conflict with the need to get things done. Continuities with Trump foreign policy are underrated. The RCEP trade agreement is not a game changer but a pro-trade shift in the US would be. Europe is a clear winner of the US election but continental politics risk will pick up next year from today’s lows. Book profits on select risk-on trades, but go strategically long GBP-EUR. Feature Global financial markets are surging on a raft of good news. We are booking some gains as we expect the rally to be capped in the near term either by Trump’s final actions as president or by the US fiscal impasse. First, the good news. The US power transition is officially under way, reducing US policy uncertainty. The popular vote within the critical battleground states acted as a restraint on the Republican Party’s ability to dispute the results or appoint Republican electors to the Electoral College.1 Chart 1US And Global Policy Uncertainty Falling President-Elect Joe Biden is preparing the US for a return to rule by experts. This will not prevent grand policy errors in the future but it will give confidence to the market today. Biden is nominating a slate of White House advisers and cabinet members who are traditional Democrats or left-leaning technocrats. For example, former Fed Chair Janet Yellen looks to serve as Treasury Secretary, longtime Biden and Barack Obama adviser Anthony Blinken as Secretary of State, and former Hillary Clinton and Obama staffer Jake Sullivan as national security adviser. Biden may nominate a few far-left officials (e.g. for the Labor Department) but the most important positions are quickly filling up with conventional faces, a boon for financial markets. Democrats are unlikely to win control of the Senate on January 5 but even if they do their single-vote majority will probably be too small to enable any radical cabinet picks – or radical legislation.2 The downside is that spending will be constrained and monetary and fiscal policy will remain uncoordinated, regardless of Yellen’s unique ability to work with Fed Chair Jay Powell. With Biden reportedly leaning on House Democrats to cut a COVID fiscal relief deal, there is a 50/50 chance that a $500-$750 billion bill passes in the “lame duck” session of Congress prior to Christmas. This would be a positive surprise. We are not counting on a deal until the first quarter next year. Hence US policy uncertainty will remain elevated. Meanwhile global policy uncertainty could spike again as long as President Trump remains in office and seeks to achieve policy objectives on the way out. Biden does not take office until January 20, but over a 12-month horizon we see a clear case for cyclical sectors and European stocks to outperform defensive sectors and American stocks as a result of Biden’s trade peace dividend, i.e. eschewing sweeping unilateral tariffs (Chart 1). Chart 2Vaccine On The Horizon While COVID-19 spikes, consumer wariness, and partial lockdowns will weigh on fourth quarter economic activity, several vaccines are on the way. The latest wave of the outbreak is already rolling over in Europe, which bodes well for the United States (Chart 2). Again, the 12-month outlook is brighter than the near term. Over the long haul, investors also have reason to be optimistic about governance in the developed world. The takeaway from this year is that the US and UK, the two major developed markets that saw right-wing populist movements win big votes in 2016, and two governments whose handling of the pandemic was at best muddled, led the development of vaccines in record time to deal with an entirely novel coronavirus and global pandemic.3 The US constitutional system withstood a barrage of partisan assaults both from President Trump and his supporters and their opponents. The British constitutional system is handling Brexit. Most other developed markets also navigated the crisis reasonably well. Weaknesses were revealed, and there will be aftershocks, but the sky is not falling. Near term US policy uncertainty will remain elevated due to fiscal impasse. Bottom Line: The rise in global risk assets may overshoot on positive news, but the US fiscal impasse could undercut the rally, as could Trump’s parting actions over the next two months. Market Not Priced For Lame Duck Trump There is a fair chance of an American or Israeli surgical strike against Iran or its militant proxies to underscore the red line against nuclear weaponization. Financial markets are not prepared for a major incident of armed conflict. Neither Israeli nor UAE equities are priced for near-term risks to materialize. The same goes for UAE or Saudi credit default swaps (Chart 3). An even greater risk to financial markets comes from the Trump administration’s pending actions on China. Trump is highly likely to take punitive or disruptive actions against China. His major contribution to US foreign policy is the confrontation with China, which was also the origin of the coronavirus and hence his electoral defeat. Already since the election Trump has imposed sanctions on US investments in state-owned enterprises. China’s fiscal and quasi-fiscal stimulus is peaking at the moment. This provides some buffer for its economy and the global economy if Trump hikes tariffs or imposes sweeping sanctions. But there are signs of instability beneath the surface. Authorities have tightened interbank rates sharply and intervened to prevent asset bubbles. The country is seeing turmoil in the bond market as a result of these actions and ongoing economic restructuring (Chart 4). Chart 3Risk Of US Or Israeli Strike On Iran Chart 4Chinese Stimulus And Bond Market Volatility Once again the market is not prepared for another major shock in the US-China relationship. The People’s Bank has allowed the renminbi to appreciate drastically this year. This trend will reverse if President Trump punishes China. As China’s economic momentum wanes and a new US administration enters office, it would make sense to allow the currency to depreciate. After all, the Biden administration will expect the renminbi to appreciate just as all previous administrations have done, but the People’s Bank will not want the yuan to fall much below the ~6.2 level that prevailed just before the trade war started in early 2018 (Chart 5). Chart 5Renminbi Priced For Zero Trump Tariffs Biden’s Foreign Policy: Continuities With Trump It is too soon to speak of the “Biden Doctrine.” Cabinet appointments will have limited impact relative to geopolitical fundamentals. Neither Biden nor Blinken have a consistent theme to their foreign policy decisions. Michèle Flournoy may or may not be nominated as Defense Secretary. What is clear is that Biden is in favor of establishment national security policymakers who want the US to work more closely with allies and international institutions. Starting in January, this shift will make US foreign policy somewhat more predictable. On Iran, Biden will seek to rejoin the 2015 nuclear deal prior to the June 18, 2021 Iranian presidential election, but he will also have reason to sustain the Arab-Israel rapprochement that the Trump administration initiated via the Abraham Accords. News reports indicate that Israeli Prime Minister Bibi Netanyahu met with Saudi crown prince Mohammad bin Salman along with US Secretary of State Mike Pompeo in a “secret” meeting on November 23. The Saudis could eventually normalize ties with Israel, but only once an Israeli-Palestinian settlement is reached. The Democrats have a long-running interest in negotiating such a settlement. Progress can be made as long as the Saudis and Israelis do not try utterly to sabotage Biden’s Iran deal. They would risk isolation from American support – an intolerable risk for both states. An American détente with Iran combined with normalized Arab-Israeli relations would create something resembling a balance in the region, which is what the Biden administration needs in order to maintain the “pivot to Asia” that will be its dominant foreign policy agenda. Biden’s pivot to Asia will start with a diplomatic “reset” with China so that strategic dialogue can resume and areas of cooperation can be identified. As Chart 5 above shows, the market is priced for Biden to reduce tariffs back to their September 2018 level (25% on $50 billion of imports and 10% on $200 billion). Anything is possible, since tariffs are an executive decision, but we would not bet on Biden sacrificing all of his leverage when the US-China strategic tensions are fundamentally rooted in the US’s loss of global standing and China’s rejection of the liberal world order. What is clear is an emerging contradiction that Biden will eventually have to resolve between multilateralism and getting things done. The Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. If Biden relies on multilateral diplomacy to update and extend the Iranian nuclear deal, he will find it much more difficult to gain Russian and Chinese cooperation than Obama did. Russia’s interference in the 2016 election and Trump’s trade war have poisoned the well. If Biden does not give enough ground to get Russo-Chinese cooperation, then he will have to use unilateral American power (i.e. Trump’s maximum pressure policy) or just settle for rejoining the 2015 nuclear deal without any safeguards against ballistic missiles or militant proxies. The original deal expires in 2025. Chart 6Greater China Still Center Of Geopolitical Risk The same goes for Biden’s handling of Trump’s China policy. Biden wants to revive the World Trade Organization. But if he adheres to the WTO then he will have to rescind all of Trump’s tariffs, since they have been declared illegal. This will reduce his leverage on unresolved structural disagreements. Biden wants to reach out to the allies on how to handle China. It is not clear how he will respond to the Trump administration’s outgoing scheme to create an alliance of liberal democracies that would arrange to purchase each other’s goods and possibly implement counter-tariffs in response to Chinese boycotts, such as the one placed on Australia today. Biden may not adopt the scheme. But the alternative would be to leave states to succumb to China’s political boycotts, thus failing to build an effective multilateral response to China’s aggressive foreign policy. China’s fourteenth five-year plan reveals that the Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. Thus we expect the Biden administration to conduct a foreign policy that is tougher on China than the Obama administration, that retains most of the Trump tariffs and tech sanctions, and that more resolutely attempts to build a coalition to pressure China into adopting international liberal norms. This policy trajectory virtually ensures that Biden will have to adopt some of Trump’s policies. Chinese equities are not priced for this risk. The pronounced risk of a fourth Taiwan Strait crisis is just starting to be recognized (Chart 6). The risk to our view is a grand US-China re-engagement. This is possible, but we think the current trajectory of China will cause a new confrontation even if Biden is less hawkish than Trump. Bottom Line: Financial markets are underrating Chinese/Taiwanese political and geopolitical risks, both from Trump’s lame duck period and from Biden’s pivot to Asia. Did China Just Take Charge Of Global Trade? Several clients have written to ask us about the Regional Comprehensive Economic Partnership (RCEP), a large new free trade agreement (FTA) signed by China and its Asian trading partners. RCEP is not a game changer but it is marginally positive for the global economy. Moreover it has the potential to ignite a new round of trade agreements, for instance by provoking the US (and the UK) to join the Trans-Pacific Partnership. RCEP is a traditional free trade agreement that will cut tariffs by an average of 90% for its members. Membership includes China, Japan, South Korea, the Association of Southeast Asian Nations (ASEAN), Australia, and New Zealand. It has not been ratified and will take ten years to fully implement after ratification. Over the past 30 years, manufacturing-oriented East Asian nations have reflexively responded to global shocks and slowdowns by deepening their trade integration. RCEP shows that this trend remains intact. China is the only member of the pact that is seeing trade grow at the moment – the others are still seeing declines due to the global recession but are hoping to increase nominal growth by removing trade barriers (Chart 7). RCEP is also notable because it is China’s second multilateral trade deal (the first was the China-ASEAN FTA). Beijing normally prefers bilateral deals where its size gives it the advantage, but it is trying to demonstrate greater willingness to work multilaterally. President Xi Jinping has rhetorically positioned himself as an advocate of free trade and multilateralism on the global stage, despite his pursuit of import substitution and state industrial subsidies at home. As long as China continues expanding trade with others it will smooth the painful restructuring of its manufacturing sector and blunt some of the criticisms about mercantilism. Ironically it is Japan’s decision to join, rather than China’s, that makes RCEP distinct. Japan did not have an FTA with South Korea and it was the only member of RCEP that did not already have a free trade deal with China. (Japan also lacked a deal with New Zealand.) This decision is not new but reflects the paradigm shift in Japanese national policy that began after the global financial crisis of 2008. In 2011, Japan signed an FTA with India. Thereafter Abenomics supercharged international trade and investment policies as part of the “third arrow” of pro-growth structural reform, which Abe’s successor Yoshihide Suga is continuing. So why is RCEP not a game changer? Because all of these countries other than Japan already have FTAs with each other and their tariff rates are already quite low. Moreover there is nothing particularly advanced about RCEP. It is a traditional deal focused on trade in goods and does not really attempt anything groundbreaking with services, or to incorporate new industries, lay down standards for labor or environment, or remove non-tariff barriers. Contrast the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the trade deal originated by the United States for Pacific Rim countries that attempts to do all these things, but was hobbled by the Trump administration’s decision to withdraw from it. The real significance of RCEP is that even as it shows continuity in Asian economic policy, with China at the center, it will also provoke new deal-making. Now that China, Japan, and South Korea are joining a single trade agreement, they will have a foundation on which to move forward with their long-delayed trilateral FTA. These developments will provoke the Biden administration into rejoining the CPTPP, which in turn would create a new higher standard type of trade bloc that has the potential to attract democracies into a high-standards bloc that excludes China. Biden will also revive the Transatlantic Trade and Investment Partnership (TTIP), the European counterpart to the Pacific deal. On the campaign trail, Biden said that he would “renegotiate” Trans-Pacific Partnership in order to rejoin it, a Trumpian formulation. This is feasible. After the US withdrawal, the various members of the Trans-Pacific Partnership modified the deal (dubbing it the CPTPP) to remove provisions that the US had insisted on and restore provisions that the US had demanded they remove. But they will gladly readmit the US now that Trump is gone, creating a trade bloc of comparable size to RCEP but with much more ambitious aims (Chart 8). The UK, South Korea, Thailand and others will be interested in joining. But China can only join if it embraces liberal reforms that are at odds with its new five-year plan, including reduced support for state-owned enterprises. Chart 7Weak Trade Prompts Asian Trade Deal Chart 8Putting RCEP Into Perspective The Republican Senate will be required to get approval for CPTPP, which is an obstacle, but Biden’s secret weapon is that the CPTPP has special appeal for Republicans precisely because it excludes China. Pro-trade moderates will find common cause with China hawks. As long as Trade Promotion Authority is renewed by the deadline on July 1, 2021, then the US can rejoin CPTPP on a simple majority vote. This is precisely how Republicans ratified Trump’s USMCA (the revised NAFTA). Trump also signed a trade deal with Japan, revealing that even under Trump’s leadership the US agreed to TPP-like deals with its biggest trading partners within the CPTPP (Canada, Mexico, Japan). More broadly, Trump’s experiment with protectionism has revealed that American attitudes toward global trade are not uniformly hostile. Polls show that Americans are generally pro-trade, and while they are skeptical that global trade creates jobs and higher wages, they are mostly skeptical of business-as-usual with China.4 Geopolitically, the US will not be able to stand idly by while China increases its sphere of influence in Asia. Therefore we should expect the Biden administration to pursue the CPTPP and other trade initiatives. The GOP Senate is the key constraint but it is not utterly prohibitive. Bottom Line: China and Asia continue to expand trade in the face of economic slowdown. The US Senate will be the key bellwether for US trade initiatives in 2021-22, but the geopolitical need to counter China will likely force the US to rejoin the CPTPP. Strategically we are long CPTPP equities – which includes some key RCEP members – as well as RCEP equities like South Korea. Chinese equities have already rallied a lot this year due to the country’s better handling of the pandemic and quicker economic recovery – they also face headwinds from US policy. Whereas emerging Asia equities ex-China, relative to all global equities, have plenty of catching up to do and will be beneficiaries of a global recovery in which both the US and China are courting them. Not Too Late To Go Long Pound Sterling The Brexit finale is approaching as the UK and EU enter the eleventh hour in their negotiation of a post-Brexit trade deal for the period after December 31, 2020. The market expects the UK, which is more dependent on EU trade than vice versa, to capitulate to an agreement that prevents a 3% tariff hike on all of its exports to the EU. This hike would occur if the UK-EU relationship reverted to WTO Most Favored Nation status. Boris Johnson promised in the Conservative Party manifesto to negotiate a trade deal and won a resounding single-party majority in December 2019. This gives him the room to marginalize hard Brexiteers and get a deal passed in parliament. The pound has rallied by 1.45% against the dollar since the beginning of the year and it is now rallying against the euro, moving off the “hard Brexit” lows (Chart 9), suggesting that the market is tentatively anticipating a trade deal. Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Failing to get a trade deal would require Johnson to break the EU withdrawal deal, since that deal requires a system of trade checks on the Irish Sea that introduces a barrier between Northern Ireland and the rest of the United Kingdom. Johnson has no incentive to stick to this deal if he does not have privileged access to the EU’s single market. But then a hard border of physical customs checks would arise on Northern Ireland’s border with the Republic of Ireland. This would not only aggravate relations with Ireland and the EU but would alienate the incoming American administration, which would view it as a violation of the US-brokered Good Friday Agreement (1998) and refuse to agree to a trade deal with the UK. Irish equities are not behaving as if a 3% tariff on all imports from the UK is about to take effect (Chart 10). Both GBP-USD and Irish equities have considerable downside if the deal falls through. The fact that the GBP-EUR appreciation is slight suggests less downside and more upside here. Subjectively we have argued there is a 35% chance that the UK will quit the EU “cold turkey” at the end of the year. The cost of more than $6 billion in foregone trade, which would grow each year, is not prohibitive. The economy is already subsisting on monetary and fiscal stimulus due to COVID-19. Boris Johnson does not face an election until 2024. The hardest limitation facing the UK is the relationship with Scotland. The hardest limitation facing the UK is the relationship with Scotland. Northern Ireland is not likely to leave anytime soon but 45% of Scots voted for independence in 2014. Support for independence meets resistance at 50% of the population (Chart 11), but an economic shock stemming from a failure to get a trade deal would push it above the limit (given that 62% of Scots never wanted to leave the EU in the first place). Chart 10Irish Equities Already Priced UK Trade Deal Chart 11Scotland Drives UK Toward A Trade Deal Johnson has the ability to conclude a deal, avoid an economic shock on top of COVID, keep the Scots in the union, and then set about overseeing his government’s mammoth economic recovery plan. His popularity is tenuous enough that the other pathway is not only more economically costly but also more likely to get him unseated and potentially to burden him with the legacy of being the last prime minister of a united kingdom. Bottom Line: It is not too late to go long GBP-EUR. A near-term global risk-off move would work against this trade but it is a strategic opportunity. Low EU Political Risk Will Pick Up In 2021 In our annual outlook for 2020 we highlighted how the EU was relatively politically stable while its geopolitical competitors – Russia, China, even the US – were far from stable. Today this is still the case – Europe’s political fundamentals are fine. But risks are rising due to partial COVID lockdowns, fiscal risks, and the approach of a series of important elections from now through 2022. A major problem for the global economy is the looming contraction in fiscal deficits in 2021 as economies step down from this year’s extraordinary fiscal stimulus measures. This downshift will be especially disruptive for the US, UK, and Italy due to the size of their stimulus packages, resulting in a fiscal drag of 5% of GDP if no additional measures are taken. But even Germany, France, and other EU members face at least a 2.5% of GDP contraction (Chart 12). Chart 12Europe's Fiscal Cliff Needs Attention Chart 12Europe's Fiscal Cliff Needs Attention Adding more fiscal support should be feasible in a world where the Fed and ECB are maintaining ultra-dovish monetary policy for the foreseeable future and the EU has agreed to allow mutualized debt issuances. Germany has embraced deficit spending in the wake of the austerity-laden 2010s, which brought significant populist challenges to the European political establishment. However, developed market economies are still highly indebted, a constraint on deficits, and those with political blockages could still have trouble passing large enough spending measures to remove the impending fiscal drag. The US faces gridlock in 2021 and therefore its fiscal cliff is a significant headwind to financial markets. One positive factor in providing fiscal support thus far is that, with the exception of Spain and the UK, European leaders and ruling coalitions have received a bounce in popular opinion this year (Chart 13). Chart 13EU Leaders’ Approval Bounced – Now What? Mark Rutte and his People’s Party for Freedom and Democracy (VVD) have benefited more than other countries but the combined support for opposition parties is rising ahead of the March 17, 2021 general election (Chart 14, top panel). A leading anti-establishment candidate has dropped out of the race. Fiscal measures will depend on the election. Chart 14Will EU Elections Really Be A Cakewalk? Chart 15European Risk To Rise On Looming Elections The German and French governments have also seen a bounce in support but need to maintain it for a longer period, as they have elections due by October 24, 2021 and May 13, 2022 respectively. French President Emmanuel Macron can still summon majorities in the National Assembly, despite losing his single party majority, and has sidelined his structural reform agenda to boost the economy. Germany is also capable of passing new measures, and has time to do so before momentum wanes amid the contest to succeed Chancellor Angela Merkel. The leadership race in the ruling Christian Democratic Union will at least raise hawkish rhetoric (Chart 14, middle panels). But markets will be placated by the fact that popular opinion is not pro-austerity at present, and the alternative to the CDU is a fiscally profligate left-wing coalition consisting of the Greens, Social Democrats, and possibly the anti-establishment hard-left, Die Linke. Spain and Italy have the least stable governments, are the likeliest to see snap elections, and thus could surprise the market with fiscal risks. Both governments lack a strong mandate and rule over a divided political scene. Italy’s Prime Minister Giuseppe Conte has seen a swell of support but he is a fairly non-partisan character and his coalition has been flat in opinion polling. It is less popular than the combined right-wing opposition, which is striving for power ahead of the fairly consequential 2022 presidential election. In Spain, not only has popular approval dropped, but the Socialist Party and the left-wing Podemos run a minority government, meaning that there is potential for gridlock to increase fiscal risk (Chart 14, bottom panels). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections (Chart 15). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections. The silver lining is that Brussels, Berlin, and the wider political establishment have become fundamentally more accepting toward budget deficits during times of distress. The ECB and European Commission Recovery Fund provide a combined monetary and fiscal backstop. Negative interest rates on debt enable fiscal largesse with minimum implications for sustainability. And none of these elections raise systemic risks regarding EU and EMU membership, other than conceivably Italy. So while fiscal risk will become more relevant in 2021, it is not a problem while COVID is still raging, and there are better chances of maintaining a fiscally proactive policy than at any previous time over the past two decades. Bottom Line: European elections and a looming fiscal drag will keep EU political risk from collapsing after the latest round of lockdowns ease. Biden And Emerging Market Strongmen Most of the emerging market strongmen – Recep Erdogan, Vladimir Putin, Jair Bolsonaro – have increased their popular support this year, benefiting from national solidarity in the face of crisis. The exception is Narendra Modi, who is struggling (Chart 16). Still, Modi has a single-party majority and four years on the election clock, and is thus more stable than Bolsonaro, who fundamentally lacks a political base despite his bounce in polls, and Erdogan, whose increase in support will fade amid a host of domestic and international challenges ahead of the 2023 elections. The US election will have limited impact on these leaders. None of them have good relations with the Democratic Party and some were openly pro-Trump. But this is only marginally negative and may not have concrete ramifications. The key is that the Biden administration will be more conducive toward a global trade recovery, will relax restrictions on immigration, will favor US diversification away from China, and will put pressure on authoritarian regimes. Chart 16Strongman Popularity Boost Will Fade Other things being equal, Biden is therefore positive for India, neutral for Brazil and Turkey, and negative for Russia. Our GeoRisk Indicators suggest that political risk has peaked for Brazil and Russia and equities could bounce back, but we think Russian political risk will surprise to the upside (Chart 17). Chart 17Political Risk Still High In Emerging Markets In the case of Russia, the Biden administration will take a more confrontational approach than previous presidents, including Obama and Bush as well as Trump. However, it still needs to rejoin the Iran nuclear deal and extend the New START (Strategic Arms Reduction Treaty) with Russia through 2026, so the pro-democracy pressure campaign will have to be balanced with negotiations. Russia, for its part, is increasingly focused on the need for domestic stability, at least until Biden makes concrete steps with NATO that threaten Russian core interests. Bottom Line: Emerging market political risk is high, the vaccine will arrive more slowly, and the Biden administration will take a tougher approach toward authoritarian regimes. This creates an opportunity for India but a risk for Russia, and is neutral for Brazil and Turkey. Strategically we are constructive on EM equities but in the near 0-3 month time frame all bets are off. Investment Recommendations With clear near-term political and geopolitical risks, and extremely elevated equity prices and sentiment, we think it is a good time to book some profits. We are closing our long global equities relative to bonds trade for a gain of 27%. Chart 18Reinitiate Long Global Aerospace/Defense Stocks We are closing our long investment grade corporate bonds relative to similarly dated Treasuries for a gain of 15%. We are closing our long China Play Index trade for a gain of 7% in recognition that China’s stimulus is nearing its peak while the Trump administration will take punitive measures in his final two months. We will also retain our long gold trade. Gridlock in the US government is not reflationary but gold is still attractive due to geopolitical risk. Strategically we recommend going long GBP-EUR. We also recommend reinitiating a strategic long position in defense stocks. Specifically, global aerospace and defense stocks relative to the broad market (Chart 18). We have been long defense stocks since 2016 but COVID decimated the trade. The coming vaccines promise to reboot the aerospace part of this trade while there was never any reason to doubt the strong basis for global defense spending amid geopolitical great power struggle.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Black Wave “What happened to us?” Black Wave seeks to answer the cardinal question facing both Middle Easterners and those looking into the Middle East from the outside.5 It takes us back four decades to events that shaped the region and walks us through time and space, politics, religion, history and culture, to where we stand – in the crosshairs of the very clash that started it all. Few are better equipped than author Kim Ghattas in doing so. A native of Beirut, she grew up amid the Lebanese civil war, living the events that created the post-1979 Middle Eastern reality. Later, she spent two decades covering the Middle East as a journalist for the BBC and Financial Times. A term first coined by Egyptian filmmaker Youssef Chahine, “black wave” characterizes the religious tide that swept Egypt in the 1990s from the Persian Gulf – one that Chahine saw as alien to Egyptians. Instead he argued that while Egyptians had always been very religious, they also had joie de vivre – enjoying art, music, talent, all taboos according to the Wahhabi interpretation of Islam. Iranians in the late 1970s were not much different from Egyptians in the 1990s. At the time, they were unified in their opposition to the Pahlavi dynasty for being too Western and corrupt. As an exile in the sacred Iraqi city of Najaf and later in the French village of Neauphle-le-Chateau, Ayatollah Ruhollah Khomeini’s speeches were capable of inspiring minds, galvanizing support, and gathering crowds. He was the right character, at the right time, but with the wrong ideas. Ideologically, Khomeini was an outsider in Najaf. The Iraqi clergy considered him too politically involved and his vision of wilayat al-faqih – a state based on Islamic jurisprudence – did not have widespread appeal. It was dismissed as outlandish by those around him who aimed to take advantage of his widespread appeal for their own gains, while hoping to limit Khomeini’s ideological influence on his audience. This proved to be a grave disregard for Iranians. 1979 was also a transformative year for Saudi Arabia. The young monarchy faced a national awakening as Juhayman al-Otaybi staged a siege on the Muslim world’s most sacred site, the Grand Mosque in Mecca. It was the first act of terrorism in opposition to Western influence – the birth of Saudi extremism – and was echoed in subsequent acts of violence in the kingdom, in 1995 and later in 2003. Fearing the spread of political Islam, the House of Saud responded by emphasizing Wahhabism, Riyadh’s homegrown Islamic movement, by empowering clerics and religious authorities. The quid pro quo was that the clerics supported the monarchy from both internal and external threats. The clash between the Iranian Revolution and Saudi Wahhabism in 1979 gave rise to the first sectarian killings. The 1987 Sunni-Shia clash in Pakistan marked the beginning of the modern day Sunni-Shia divide, spreading through Pakistan and eventually the Middle East to Lebanon, Iraq, and Syria. Today, as youth across the Middle East struggle in despair of the aftermath of these events, Ghattas sees hope. Protests ringing from Beirut to Baghdad call for a post sectarian political system. The Saudi monarchy is relaxing its puritanical grip, and a new generation brings newfound hope of rectifying past miscalculations. We ultimately agree with Ghattas’s optimism that these changes are hopeful indications that the people of the Middle East are ready to shift gears and move past the conflicts that have dominated the past four decades. However, there are other forces at play and the Saudi-Iranian rivalry is still a dominant feature of the region’s geopolitical landscape. True, Ghattas’s account not only highlights how deeply engrained the conflict is, but also that the early signs of tidal shifts can be easily missed. But we cannot ignore the specter of near-term risk facing the Middle East that continue to challenge its economic and political ascent. Thus, from an investment standpoint, we favor a more cautious approach and remain on the lookout for a better entry point once the near-term manifestation of these long-standing hurdles are overcome.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Supreme Court could still rule that Pennsylvania should have stuck with its November 3 deadline for ballots, but such a ruling would not change the outcome of the election. As with Florida following the disputed election in 2000, the various states’ electoral systems will likely be stronger as a result of this year’s polarized contest and narrow margins. 2 Biden could use the Vacancies Act or recess appointments to ram through his cabinet picks, but it would be controversial and at present he looks to be taking advantage of the Republican veto to nominate center-left figures that are more ideologically lined with his lane of the Democratic Party. 3 US-based Moderna developed one vaccine while US-based Pfizer and Germany-based BioNTech developed another. The Anglo-Swedish company AstraZeneca jointly developed its vaccine with Oxford University. Vaccine trials were administered across these countries and others, including South Africa, India, Brazil, and the entire global health care and pharmaceutical supply chain contributed. 4 See Pew Research. 5 Kim Ghattas, Black Wave: Saudi Arabia, Iran, and the Forty-Year Rivalry That Unraveled Culture, Religion, and Collective Memory in the Middle East (New York: Henry Holt, 2020), 377 pages. Section II: GeoRisk Indicators China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil   Section III: Geopolitical Calendar

Highlights There is some evidence that the euro could gravitate to 1.50 over the next few years. The key assumption is that the equilibrium rate of interest will rise in the euro area relative to that in the US. Our bias is that fair value for the euro is closer to 1.35, or 15% above current levels. Over the very near term, the risks are tilted towards the downside. But while EUR/USD could punch below 1.15, an undershoot towards parity is highly unlikely. In our FX portfolio, we are long EUR/CHF and short EUR/GBP. We would buy the euro outright below 1.15. Feature The markets have rejoiced at the success of a few vaccine trials and are looking forward to a return to normalcy in 2021. Around the world, equity markets have rallied in symphony. Even secular dogs such as the Japanese Nikkei, which has been in a relative bear market for many decades, broke to fresh 21-year highs. Copper prices are rising fervently, and measures of risk, such as the VIX index or high-yield corporate spreads, are collapsing to pre-pandemic levels both in the US and Europe. As a procyclical currency, the euro has also been quite cheerful. Bullish sentiment on the euro is at a decade high and the currency has rallied 11% from the lows, commensurate with the drop in the DXY index (Chart 1). As a share of total open interest, 80% of speculators are bullish on the euro. Historically, sentiment at this level has been usually associated with the euro being closer to 1.50. Chart 1Sentiment On The Euro Is Elevated Chart 2The Euro Is Lagging Copper Prices The juxtaposition of much welcomed good news and elevated sentiment sets the euro in a very precarious tug of war. Standard theory suggests that the post-pandemic trade may already be priced into the common currency, given bullish sentiment. This augurs for a reversal. On the other hand, other measures also suggest that the rally in the euro has more room to run. For example, copper prices and the euro have tended to move together, and the red metal suggests EUR/USD should be above 1.20 (Chart 2). Similarly, EUR/JPY has lagged the stellar performance of global equity prices. Is the lagging performance of EUR/USD sending the right signal, suggesting caution? Or is the common-currency a coiled spring ready to head much higher in 2021? How To Forecast The Euro According to Bloomberg forecasts, the euro will be at 1.25 by the end of 2022 (Chart 3). By our reckoning, these forecasts are much too pessimistic. The key driver of the EUR/USD exchange rate is the relative growth profile between the euro area and the US, how that profile is likely to evolve in the future, and the implication for relative monetary policies. Anything else that tries to predict the euro is a subset of this much bigger question. How is growth in the euro area likely to evolve compared to the US? There are many ways to approach this issue, with surprisingly similar results. The key driver of the EUR/USD exchange rate is the relative growth profile between the euro area and the US. The first is just to take the IMF growth estimates at face value. According to the Fund, the euro area economy is projected to contract by 8.3% this year, almost double that of the US, which is 4.3%. But by next year, the economy is expected to bounce back more fervently. Euro area growth is expected to advance by 5.2% compared to 3.1% in the US. Much of the rise will be due to a surge in investment within the euro area, especially driven by pent-up demand in the peripheral countries. This growth acceleration is projected to continue well into 2023. Back-of-the envelope calculations suggest that this will pin EUR/USD around 1.35 (Chart 4) Chart 3Few Expect The Euro Above 1.25 Chart 4EUR/USD And Relative Growth The Case For European Growth We tend to side with the IMF’s forecasts and even argue that this might actually be on the conservative side for the euro area. There are two major reasons for this, both of which are bilaterally important. First, the neutral rate of interest in the euro area may have moved a step function higher relative to the US. The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. The silver lining is that the European Central Bank (ECB) has now lowered domestic interest rates and eased policy to the point where they are accommodative for all euro zone countries.1 Bond yields in peripheral Europe are collapsing relative to those in Germany and France (Chart 5). This makes it much easier for the less-productive, peripheral countries to borrow and invest. This will boost productivity, lifting the neutral rate. Chart 5The Neutral Rate In The Euro Area Second and equally important, the periphery has become as competitive as the core. Through labor market reforms, internal devaluation, and recurring recessions throughout the last decade, unit labor costs in Greece, Ireland, Portugal, and Spain have converged with that in Germany and France. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart 6). Even Italy, which remained saddled with a rigid and less productive workforce, has seen unit labor costs begin to crest. Chart 6Southern Europe Is Competitive Again According to the Holston-Laubach-Williams estimates at the NY Fed, the natural rate of interest in the euro area is now higher than in the US, something that has rarely occurred over the 20-year history of the common currency. Based on these estimates, the euro could gravitate towards 1.50 (Chart 7). Chart 7EUR/USD And The Neutral Rate US Versus Europe Chart 8Productivity In Europe Has Lagged In today’s world, 1.50 for the euro is certainly very high and will surely stir up some action from the ECB well before we approach these levels. As most of my colleagues would argue, no central bank wants a strong currency.2 But how can we gauge the above premise that the neutral rate of interest should be higher in the euro area due to the tectonic shifts over the last few years? One way is to look at trend productivity growth. Since the 1960s, up until the Great Financial Crisis, trend productivity growth was around 2.2% in the US and 2.8% in the euro area. However, since 2009, productivity growth has been 0.6% per year in the euro area and 1.1% in the US (Chart 8). In other words, the European debt crisis has substantially subdued productivity growth in the euro area. If indeed the crisis is behind us, and we assume European productivity growth returns back to trend over the next 10 years, while making up for the shortfall relative to the US, this will pin it at roughly 1.6% higher in Europe relative to the US. Cumulatively, that is a rise of around 20%. Meanwhile, we highlighted last week that the euro was undervalued by over 10%.3 This pins the euro above 1.50. The Euro At Parity And Inflation Chart 9US Versus Euro Area Inflation While the euro might gravitate higher in the next few years, it is unlikely to do so in a straight line. Meanwhile, deflation is a key near-term threat for the euro (Chart 9). With the ECB clearly telegraphing that it will do more easing in December, the relative monetary policy stance is not favorable. That said, there are three key points to consider about inflation. First, most G10 central banks were unable to meet their inflation mandate when output gaps were closing and the economy was at full employment. This makes it less likely they will meet their mandate anytime soon. This is not just an ECB problem, but one for the Fed, BoJ, and even the RBA. Second, inflation tends to be a global phenomenon in the developed world, meaning desynchronized cycles in inflation dynamics are quite rare. Finally, with balance sheets expanding everywhere in the G10, the potential for higher inflation once output gaps close will be universal. European productivity growth will have to outpace that in the US by roughly 1.6%, to play catch up. Going forward, an agreement on the mutualization of European debt means we can begin to expect more synchronized business cycles as fiscal stabilizers kick in. The reason is that both fiscal and monetary policy can now be synchronized across member states. This makes shortfalls in inflation less likely. Finally, while deflation can be a sign of an expensive currency, there is little evidence that this is the case for the euro. The euro area continues to sport very healthy trade and current account surpluses, a sign that the euro remains very competitive among its trading partners. Intra-European trade represents a large share of cross-border transactions in Europe, meaning currency considerations are less important. In 2019, most member states had a share of intra-EU exports of between 50% and 75%. The bottom line is that disappointing inflation dynamics could lead to a knee-jerk selloff in the euro, but this should be an opportunity to accumulate long positions. The Cyclical Catalyst Ultimately, European growth is cyclically tied to export growth. And with a huge concentration of cyclical sectors, such as financials, industrials, materials and energy, in European bourses, the euro tends to be largely driven by pro-cyclical flows. Earnings revisions between the euro area and the US have generally led the EUR/USD exchange rate by about 9-12 months (Chart 10).  Chart 10EUR/USD Tracks Relative Profits So far, the signs are positive. The impulse from Chinese credit is providing a release valve for European exports (Chart 11). So even if social distancing remains in place for longer than people expect, it still allows economies that are geared more towards manufacturing such as Europe, Japan, and China to keep churning higher. This could boost European earnings in a meaningful way. Chart 11Chinese Demand For European Goods Fortunately for investors, European equities, especially those in the periphery, remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world (Chart 12A). Over the next decade, it would be surprising if some of these “old economy” stocks did not unwind their discount via both rising earnings and multiples. Many emerging markets, including China, still depend on “old-economy” materials such as oil, and industrial machinery, that Europe sells. The impulse from Chinese credit is providing a release valve for European exports. Even in the commodity space, cyclical metals like copper are still massively underperforming safe havens like gold. This has largely  tracked the discount between European stocks and US stocks. A bet on a reversal could prove very profitable (Chart 12B).   Chart 12AEuro Stocks Are Cheap Chart 12BEuro Stocks Could Rerate Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest," dated June 14, 2019, available at fes.bcaresearch.com 2 Please see Global Fixed Income Strategy Weekly Report, "Nobody Wants A Strong Currency," dated November 17, 2020, gfis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "Updating Our PPP Models," dated November 13, 2020. fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In the first nine months of 2020, China's capital outflows, measured by the Balance of Payments (BoP) data, have been the largest since 2016. Unlike 2016, the outflows are mainly driven by a strategic accumulation of foreign currency (FX) assets by domestic entities rather than capital flight. Chinese banks may have been using some of their FX holdings and transactions to slow the pace in the RMB appreciation.  The RMB can still devalue relative to the USD in the next two months, but in the next 6-12 months, the RMB should continue to revert to its pre-trade war value. Feature Chart 1Large Capital Outflows Despite A Strong RMB China’s official BoP data imply that approximately $200 billion capital left the country in the first three quarters of the year, the largest amount since 20161 (Chart 1). The large capital outflows occurred when China’s post COVID-19 economic recovery was strengthening, the current account surplus was surging, and both direct and portfolio investment flows were net positive.  Moreover, unlike 2015-16 when capital outflows were driven by, and in turn, reinforced the depreciation in the Chinese currency, the RMB has been strengthening against the USD. In this report, we examine China’s BoP data and related figures, and use the framework from a previous Special Report to assess China’s capital outflows.2 Our research shows that at least a good portion of the capital outflows was likely an effort by Chinese policymakers to slow the pace of the RMB’s appreciation against a basket of its trading partners’ currencies. A Puzzling BoP Picture Official BoP data shows that China’s current account surplus was $170 billion in the first three quarters of this year, and net FDI and portfolio flows totaled at $54 billion. The surplus has been mostly offset by an estimated $155 billion of “Other Investment” outflow in the non-reserve FX account and $53 billion in Net Errors and Omissions (Table 1). Table 1China’s Balance Of Payments During the 2015-16 period, large outflows were driven by reduced foreign inflows, domestic firms paying down US dollar debt, and enterprises and households moving their assets overseas.  This time, however, the outflows appear to be largely government driven and strategic FX asset accumulations, and most likely through Chinese state-owned banks and institutional investors. Chart 2FX Settlement Has Been Net Positive Chart 2 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks. This is drastically different from the deep contraction in the net settlement data following the RMB devaluation in August 2015. Chart 3 also highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady this year. This implies that domestic firms are not rushing to pay off their external debt as was the case in 2015/16. Chart 3Chinese Firms Are Not Rushing To Pay Off External Debt Chart 4Relatively Low Level Of Illicit Capital Outflows Moreover, service trade deficits from outbound tourism have narrowed substantially due to international travel restrictions, which have made it difficult for Chinese residents to move capital out of the country. Additionally, the illicit capital outflows through import over-invoicing are very low (Chart 4). Hence, a large negative reading in the “Other Investment” and “Net Errors and Omission” categories implies an accumulation of FX assets by China’s banks and intuitional investors. The net FX asset accumulation by commercial banks was $117 billion in the first nine months, largely offsetting the $170 billion current account surplus in the same period. A closer examination of BoP data also shows that in June the PBoC recorded a $118 billion fund transfer from a FX asset balance sheet, which has otherwise been flat over the past five years. It is unclear where the funds have gone, but coincidently the amount matches a $118 billion outflow in the BoP’s non-reserve FX assets during the same quarter (Chart 5). China’s non-reserve FX assets3 are mostly in offshore investment and lending, which is intermediated by a small group of state-owned entities. Given that external lending through China’s banks and financial institutions has slowed in the post-COVID-19 environment, direct and portfolio investments must have been the main sources of the FX asset accumulation (Chart 6). Chart 5Unexplained FX Fund Transactions Chart 6No Sign Of Extended Loans Or Trade Credit Capital Outflows As An Exchange Rate Stabilizer The sharp rise in the trade surplus and foreign capitals into China’s bond market this year explains the upward pressure on the RMB. Chinese policymakers may have been trying to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by large state-owned banks and other financial institutions. Following the devaluation of the RMB in August 2015, China had to liquidate a quarter of its official FX reserves to defend the currency. The rapid depletion in the official reserves fueled market jitters and reinforced the RMB depreciation. The FX assets held by China’s state-owned banks and institutional investors, on the other hand, can mostly fly under the radar and, in recent years, may have become the policymakers’ preferred channel of regulating fluctuations in the currency market. We tested this theory by assessing the relationship between the net FX purchases by China’s banks and the RMB exchange rate against the USD and a basket of its trading partners’ currencies (measured by the CFETS index). The latter is the exchange rate reference regime that China switched to in 2017.4 The official “net FX settlement by bank itself” data series represents the difference between the banks’ purchases and sales of foreign exchange in the interbank system. We exclude settlements and sales by banks on behalf of clients to filter out the demand for FX from enterprises and households. Chart 7 shows that, prior to 2018, the banks’ net FX purchases ticked up when the RMB appreciated against the USD, and banks sold more FX when the USD rose against the RMB. The interventions intended to slow the market move in either direction to keep the USD/CNY exchange rate swings within the PBoC’s comfort zone. Chart 7Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Chart 8Since 2018 China Targeted A Basket Of Currencies Interestingly, the tight relationship loosened somewhat after 2018. On several occasions, banks made more FX purchases even when the RMB was weakening against the USD. It appears that since US tariffs on Chinese goods began in 2018, Chinese policymakers have been more willing to allow market forces drive down the RMB in relation to the USD. Meanwhile, China has targeted a relatively stable value of the RMB against a basket of its trading partners’ currencies in the CFETS index. As Chart 8 (top panel) illustrates, since 2018, net FX purchases by Chinese banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (both rebased to December 2014=100). When the RMB falls relative to the USD but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate or raise the value of other currencies in the CFETS basket (Chart 8, bottom panel). Investment Conclusions Chart 9Mean Reversion In The USD/CNY Will Continue The market sentiment has been overwhelmingly bullish on RMB. Partially, the CNY/USD market has been pricing in the possibility of a Biden administration in the US, and improved Sino-US relations. In our view, the RMB has not moved into outright expensive territory and will continue to revert to its pre-trade war value against the USD in the next 6-12 months (Chart 9). In the next two months, however, the RMB may still give back some of this year’s gains against the USD. A contested US election may bring negative surprises to the global financial markets. The COVID-19 pandemic also remains a headwind in Europe and North America until a vaccine is widely available. As such, the USD will likely have a near-term countercyclical rebound. In fact, a depreciation in the RMB would be a boon to China’s domestic economy as it currently faces disinflationary pressures. Meanwhile, the net FX settlement among Chinese banks has been trending sideways in the past three months, which signals that Chinese policymakers may be comfortable with the RMB’s current value. We think China will allow the RMB to appreciate against the USD as long as the RMB does not climb too rapidly against the basket of other major currencies. If the upward pressure on the RMB continues to push the CFETS index higher, then China may choose to step up its purchases of FX assets. Assets in Euro, the Japanese Yen, and the Korean Won may be high on the shopping list (Chart 10 and Chart 11). Chart 10China May Step Up Purchases Of Other Major Currencies Chart 11The CFETS RMB Index Composition     Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1Based on the Balance Of Payments methodology, short-term capital outflows = current account surplus + changes in reserve assets + direct investment ≈ net flows in portfolio investment + net flows in other investment + net errors & omissions. 2Please see China Investment Strategy Special Report "Monitoring Chinese Capital Outflows," dated March 20, 2019, available at cis.bcaresearch.com 3FX assets held at banks and financial institutions other than the PBoC. 4CFETS RMB Index refers to CFETS (China Foreign Exchange Trade System) currency basket, including CNY versus FX currency pairs listed on CFETS. The sample currency weight is calculated by international trade weight with adjustments of re-export trade factors. The sample currency value refers to the daily CNY Central Parity Rate and CNY reference rate. Cyclical Investment Stance Equity Sector Recommendations

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The DXY is still overvalued by 13%, despite the 10% drop since March. The Scandinavian currencies remain very cheap. The Japanese yen should be a core holding in every currency portfolio. It is cheap relative to the US dollar, and a great hedge against market volatility. Outside the US dollar, the New Zealand dollar is also expensive. Our positioning is largely in line with PPP fundamentals. Stay short EUR/GBP, CAD/NOK, NZD/CAD and USD/JPY. We are also long a basket of petrocurrencies (NOK, CAD, RUB, MXN and COP) against the euro. Feature Inflation dynamics are a very powerful determinant for the trajectory of a currency. If inflation is high and rising in one country relative to another, then the currency should depreciate to equalize prices across borders. Otherwise, the high-inflation currency becomes incrementally expensive. Over time, by gauging relative shifts in prices, one can ascertain where a currency rests relative to its long-term fair value. This is the basic theory behind purchasing power parity (PPP).   In practice, PPP can be a very poor timing tool for managing currencies. Inflation tends to be a lagging indicator, making timely decisions based on PPP modeling futile. Meanwhile, there are also measurement issues, given the difference in consumer price baskets across countries. For example, shelter is 33% of the US CPI basket but only 17% in the euro area. The rising share of services in many economies also renders the PPP exercise less relevant, given the difficulty is arbitraging those prices away. It is rather difficult to import a haircut from Manila into Canada, though there could be a huge price differential. US inflation has been blasting downwards since the start of the year and by most indicators will remain very tepid in the near term.  That said, there are two crucial benefits that come from the PPP exercise. First, most currencies tend to be mean reverting around their PPP fair value. This is especially true if the deviations from fair value are especially large. For developed market currencies, 20-30% deviations from fair value are extremely rare, making such occurrences very potent bets for a reversal. Second, by creating a synthetic CPI basket for each country that equalizes the weights of various items across countries, one gets much closer to an apples-to-apples comparison.1 The Adjustment Chart I-1The Dollar Move This Week Was Unusual We make two adjustments. First, we divide the CPI baskets into five major groups. Second, we run two regressions with the exchange rate as the dependent variable. The first regression (REG1) uses the relative price ratios of the five groups2 as independent variables. This allows us to observe the most influential prices that help explain variations in the exchange rate. The second regression (REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, household goods are 3% in the US CPI basket, but 9% in the Australian CPI basket, a new synthetic price basket will have a 6% weight for household goods. Given the big move in currencies since the March 19 peak in the DXY index, we are updating these models to see where value lies within the G10 and to provide a more grounded anchor to our relative value trades. The results show the US dollar as still overvalued, especially versus the Swedish krona and Norwegian krone (Chart I-1). Within the safe haven complex, the Japanese yen remains very attractive. The rally in the euro has eroded the valuation cushion that was much evident at the start of the year. Our positioning is largely in line with PPP fundamentals. We are short EUR/GBP, CAD/NOK, NZD/CAD and USD/JPY. We are also long a basket of petrocurrencies (NOK, CAD, RUB, MXN and COP) against the euro. This is a play on both relative fundamentals and valuation. The US Dollar Chart I-2Downside Risks To US Inflation US inflation has been blasting downwards since the start of the year and by most indicators will remain very tepid in the near term (Chart I-2). This could force the hand of the Federal Reserve into injecting more stimulus into the economy. Services remain a very important component of US CPI, especially shelter. The shelter CPI (33% of the consumption basket) component has dramatically softened from about 3.3% at the start of the year to about 2% today. That said, prices have been disinflationary globally and not just in the US. This means that despite the drop in US CPI, the fair value of the currency continues to fall given weaker prices outside the US (Chart I-3). According to REG2, the US dollar is still overvalued by 13%. REG1 has a higher fair-value for the currency, since household good and transportation prices have been drifting lower in the US and are captured more fervently in this regression. Our long-term view on the US dollar remains bearish. The Fed now has an asymmetrical inflation target. This means willingness to allow for an inflation overshoot, as the Fed will not fight upside surprises in inflation with tighter monetary policy anytime soon. This will dampen the long-term fair value of the US dollar, compared to its G10 peers. Chart I-3The Dollar Is Expensive The Euro Chart I-4The Euro Is Cheap The euro area has stepped back into deflation, at a time when the European Central Bank is running out of monetary policy bullets. Annual CPI in September came in at -0.3%, which explains why the fair value of the euro has been rising relative to the USD (Chart I-4). Most components of the CPI basket in the euro area are declining, including household goods, medicare and shelter. With the pandemic hitting the euro area very hard, food, restaurants and hotels (food and non-alcoholic beverages account for 29% of the consumption basket) have fallen. This has buffeted the fair value of the euro. Shelter's weight in the euro area CPI basket currently stands at 17%. This is a small share compared to the US. This means that more subdued house and rental price increases in the euro area have been beneficial for the fair value of the common currency. Rampant rent controls, especially in places like Germany, have subdued housing CPI. These trends should continue. It is well known that the euro area is relatively open; as such, tradable goods prices are important for the fair value of the euro. On this front, there has been a generalized downtrend in euro area tradeable goods prices. Compared to the Fed, the ECB can do little about this. This is relatively euro bullish, since it will boost real rates and lift the fair value of the currency. The Japanese Yen Chart I-5The Yen Is Quite Cheap The yen remains cheap and is undervalued by both measures around 15% (Chart I-5). Falling relative prices in Japan is the norm, which makes the yen relatively attractive on a recurring basis. Shelter prices have been the big component in the relative decline of Japanese prices. Other prices have been decreasing, especially in culture and recreation where the boom in the tourism industry was crushed by the pandemic. The new Prime Minister, Yoshihide Suga, continues to encourage deflation by targeting lower telecom prices. This is reinforced by the aging population. Encouragingly, BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, even though inflation expectations have not been trending in his favor. That means inflation in Japan will likely lag that of other developed countries, lifting the fair value of the yen. The British Pound Chart I-6The Pound Is Cheap While the pound might be driven near-term by political gyrations on the conclusion of Brexit, it is fundamentally undervalued. REG2 suggests the pound is undervalued by 17%. (Chart I-6). The consumption baskets in both the UK and the US are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials. Relative food and restaurant prices have gone up as the UK economy reopened, but energy and transportation costs are down since the oil crisis took hold. Brexit will continue to dictate the ebb and flow of sterling gyrations over the next few weeks, but the reality is that the pound should be higher on a fundamental basis. We are long cable versus the euro on this basis. The Australian Dollar Chart I-7The Aussie Is Slightly Cheap The AUD is undervalued by about 3% as the discount has fallen with the bounce in the Aussie (Chart I-7). As a commodity currency, PPP models are less useful for the AUD than terms of trade, which have been moving in favor of the Australian dollar. Most prices in the Australian consumption basket are up relative to the US. This is especially the case for health, culture and recreation, as well as household goods. Shelter accounts for almost a quarter of the consumption basket. Relative shelter prices in Australia have been improving of late, on the back of waning macro-prudential measures. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, and more by RBA policy and terms of trade. The New Zealand Dollar Chart I-8The Kiwi Is Slightly Expensive The New Zealand dollar is overvalued by about 5% relative to the US dollar, according to our PPP models (Chart I-8). Like the Aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have been moving against the kiwi. Relative shelter prices in New Zealand, which were flat for most of this decade, are reaccelerating anew on low rates and government support. Inflation has moderated considerably in New Zealand since the pandemic hit the global economy. This should keep the fair value of the kiwi stable. Our bias is that going forward, the kiwi will underperform other commodity currencies on valuation grounds. The Canadian Dollar Chart I-9The Loonie Is Cheap The loonie is currently undervalued by about 10% against the US dollar (Chart I-9).  Shelter remains the largest budget item for Canadian households, and relative prices have been rising. Interestingly, shelter CPI does not fully capture skyrocketing house prices in Canada over the last decade, due to measurement differences in owner’s equivalent rent. Since 2005, Canadian house prices relative to the US have doubled but, on the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the CPI explanatory power of the exchange rate. Due to heavy taxation, Canadian consumers are not benefitting from the steep drop in energy costs compared to their US neighbors. Relative energy and transportation costs are up in Canada. That said, terms of trade have been more important for the loonie. As such, rising energy prices will be positive for Canadian incomes and the fair value of the loonie. The Swiss Franc Chart I-10The Swiss Franc Is Cheap USD/CHF is expensive according to our PPP models, despite a structural appreciation of the franc in recent years (Chart I-10). This has been driven by a relative price decline in all categories of the Swiss consumption basket. A large item in the Swiss CPI basket is the food, restaurants and hotels category, and this has been in structural relative price decline. But even more volatile items, such as energy and transportation, have declined of late as well. Headline consumer prices in Switzerland are down -0.6% year-on-year, one of the worst in the developed world. This has significantly boosted the fair value of the franc. As a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are doing well as imported goods prices continue to deflate. This suggests that Swiss innovation will continue to drive the value of the franc higher. The Norwegian Krone Chart I-11The Norwegian Krone Is Very Undervalued The Norwegian krone is one of the most undervalued currencies, according to our PPP models (Chart I-11). A big swing factor for the krone has been falling energy prices. As a large energy producer, Norwegians pay less for electricity, gas and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices, even though it is extremely beneficial for terms of trade. As such, the drop in energy prices has eroded the valuation cushion for the NOK, but not by enough to significantly dent deep undervaluation. The Swedish Krona Chart I-12The Swedish Krona Is Very Cheap The krona is the cheapest currency in our universe by a wide margin (Chart I-12). Relative prices in Sweden have been rising, but not by enough to dent the undervaluation in the currency.  Sweden kept its economy mostly open during the entire duration of the pandemic. As such, relative prices, especially those for services such as restaurants and hotels, have held up relatively well. Energy prices have also been a big swing factor in the CPI basket, with the cheap krona boosting domestic fuel costs. Negative rates have also been a boon for the housing market, with prices for both shelter and homes picking up relative to the US. The bottom line is that modest inflationary pressures are to be expected given the steep undervaluation of the krona. But it will require a lot more of a rise in domestic prices to dent the fair value of the SEK.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Special Report, titled “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 2 Group A: Food, restaurants and hotels; Group B: Shelter; Group C: Health, culture and recreation; Group D: Energy and transportation; Group E: Household goods Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been mostly positive: Nonfarm payrolls increased by 638K in October, higher than the expected 600K. The unemployment rate declined from 7.9% to 6.9% in October. The NFIB Business Optimism Index was unchanged at 104 in October. Headline inflation fell from 1.4% to 1.2% year-on-year in October. Core inflation also slipped from 1.7% to 1.6%. Initial jobless claims increased by 709K for the week ending on November 6, better than expected. The DXY index fell by 0.4% this week. Risk appetite made a tentative come back earlier this week while downside risks persist. A confirmed Biden presidential victory, together with positive vaccine news from Pfizer make a stronger case for our long-term dollar bearish view. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been negative: The Sentix Investor Confidence Index declined from -8.3 to -10 in November, while still above the expectations of -15.  The ZEW Economic Sentiment Index declined from 52.3 to 32.8 in November. Industrial production fell by 6.8% year-on-year in September. The euro increased by 0.4% against the US dollar this week. We expect the euro to outperform the US dollar should global growth recover in the coming months. Many economic indicators are consistent with this view: the trade balance in the euro area remains very positive; relative bond yields are quite attractive; lastly, the gap between the economic surprise index with the US is also closing. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been positive: The Coincident Index slightly increased from 79.4 to 80.8 in September. The Leading Economic Index also ticked up from 88.5 to 92.9. Preliminary machine tool orders declined by 5.9% year-on-year in October. This is a considerable improvement compared to the 15% drop in the previous month. The Eco Watchers Survey Outlook Index increased from 48.3 to 49.1 in October. The Current Index also climbed from 49.3 to 54.5. The Japanese yen declined by 0.8% this week against the US dollar with a more optimistic backdrop for global growth. That said, we continue to favor the Japanese yen as a safe-haven hedge as the yen could still outperform the US dollar in a pro-cyclical environment. The Summary of Opinions released by the BoJ this week highlighted that Japan’s economy is likely to follow an improving trend at a moderate pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the UK have been positive: GDP increased by 15.5% quarter-on-quarter in Q3, following the 19.8% plunge in the previous quarter. Halifax house prices increased by 7.5% year-on-year over the past three months to October. Retail sales increased by 5.2% year-on-year in October. The British pound appreciated by 1.1% against the US dollar this week. The UK is one of the countries hit hardest by COVID-19 as its services sector is a large component of GDP. The UK is also well prepared for the vaccine this time and is likely to benefit most from the vaccine distribution. We remain bullish on the British pound and are playing the GBP upside via the euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been positive: The NAB Business Confidence Index increased from -4 to 5 in October. The NAB Business Conditions Index also ticked up from 0 to 1. The Australian dollar appreciated by 1.2% against the US dollar this week. As the NAB November 2020 Global Forward View pointed out, incoming GDP data confirms a substantial but incomplete rebound in the third quarter globally. Besides, stronger manufacturing conditions in the EM space firmly support the Australian economy and the Aussie dollar. Moreover, the RBA’s policy remains highly accommodative, which should support domestic economic activity. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data from New Zealand have been mixed: REINZ house prices increased by 3.5% month-on-month in October. Visitor arrivals continued to fall by 96.7% year-on-year in September. Two-year inflation expectations edged up from 1.43% to 1.59% in Q4. The New Zealand dollar surged by 2.4% against the US dollar this week. On Wednesday, the RBNZ held the official cash rate unchanged at 0.25% and sounded more optimistic about the economic outlook. This was a marked difference from market expectations of negative rates. The bank did reaffirm a funding for lending program, which will allow banks to obtain cheap funds for lending. This was esteemed more potent than a negative OCR. That said, the Bank is ready to deploy negative rates by year end if needed. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been positive: The unemployment rate declined from 9% to 8.9% in October. The participation rate ticked up from 65% to 65.2%. Average hourly wages increased by 5.3% year-on-year in October. Employment increased by 84,000 in October. Bloomberg Nanos Confidence was unchanged at 52.5 for the week ending on November 6th. The Canadian dollar appreciated by 0.6% against the US dollar this week. Higher hopes for a vaccine provide a positive backdrop for the transportation sector, supporting energy prices and petrocurrencies including the Canadian dollar. We remain positive on the CAD against the USD while negative on the CAD against higher beta petrocurrencies such as the NOK. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: The unemployment rate fell from 3.4% to 3.3% in October. FX reserves declined from CHF 873.5 billion to CHF 871.5 billion in October. Total sight deposits were unchanged at CHF 707.6 billion for the week ending on November 6. The Swiss franc remained flat against the US dollar this week. While we are positive on the Swiss franc against the US dollar, we do think that the Japanese yen is a better hedge than the franc. Moreover, as we argued in last week’s report, an interesting gap has been opened between EUR/CHF and USD/CHF. Our bias is that the euro will outperform the Swiss franc in coming months. Stay long EUR/CHF. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been mostly positive: Manufacturing output fell by 0.5% month-on-month in September. Headline inflation increased from 1.6% to 1.7% year-on-year in September. The Norwegian krone appreciated by 2.3% against the US dollar this week. The Norges Bank decided to keep the policy rate accommodative at low levels last week to support economic recovery. Our Commodity and Energy strategists now forecast Brent prices to reach $65 - $70 /bbl by 2025. We believe that the Norwegian krone will follow the energy price higher as travel restrictions are being lifted in the post-vaccine world. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been mostly negative: The budget deficit widened from SEK 13 billion to SEK 36 billion in October. Household consumption fell by 3.8% year-on-year in September. Headline inflation declined from 0.4% to 0.3% year-on-year in October. The Swedish krona appreciated by 1.7% against the US dollar this week. Scandinavian central banks, including the central banks of Norway, Sweden and Denmark, have entered into a new agreement for currency swap facilities to strengthen contingency. This will help cushion further damages from a prolonged health crisis. We continue to favor the Nordic currencies and will buy the Nordic basket again on 2% drop. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades