Asia

Dear Client, Next week we will be sending you a Special Report providing our insights on the much-anticipated China National People’s Congress. We think the messages sent from the conference will be highly relevant to both the global economy and financial markets. Please note: instead of Wednesday, the Special Report will be published on Thursday the 28th of May. Best regards, Jing Sima China Strategist Highlights Insert HiEarly signs suggest a renewed appetite among Chinese consumers for real assets and durable goods. China’s discretionary consumption will likely benefit greatly from pro-growth measures, and recover much faster than the aggregate consumption.   The unemployment rate has been rising and largely concentrated in lower-income workers. Elevated unemployment will be a drag on China’s overall consumption, but its impact on discretionary consumption is limited. We are initiating two trades: long investable consumer discretionary/short investable consumer staples and long domestic consumer discretionary/broad A-share market. Feature Chart 1Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Economic data released last week showed that China’s economy continued to recover, particularly the infrastructure, construction and high-tech sectors (Chart 1). On the other hand, household consumption, which accounts for nearly 40% of the country’s economy, remained in a deep contraction in April. While we think the annual growth in China’s aggregate household demand will remain muted this year, the breakdown in April’s retail sales data suggests that the speed in consumer discretionary spending is already accelerating (Chart 2). During economic recoveries, consumer discretionary spending usually rebounds ahead of a recovery in overall consumption. Even though the current economic downturn is extra-ordinary, we believe that China’s discretionary consumption growth will pick up faster and stronger than the aggregate household consumption. Consumer discretionary stocks, an early cyclical sector in China’s equity market, troughed about 3 months ahead of a bottoming in Chinese investable and domestic stock prices in previous cycles. In line with our constructive view on Chinese stocks in the next 6 to 12 months, we recommend investors overweight Chinese consumer discretionary stocks relative to the benchmarks. In addition, we are initiating a long position in investable consumer discretionary versus investable consumer staples, and a long position in domestic consumer discretionary versus A-share market. Chart 2Discretionary Consumption Is Rebounding Faster Than Staples A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks China’s Stimulus-Driven Consumption Cycles Chinese consumption cycles since 2008 have mostly reflected the effectiveness of China’s pro-consumption and stimulus policies. So far, the Chinese government’s stimulus measures have been concentrated in the corporate sector rather than households. Nevertheless, government pro-growth measures, flush liquidity in the market and global travel restrictions should provide a lift to domestic sales of durable and luxury goods. Chart 3 illustrates how, in contrast to the US, China’s retail sales have grown faster than nominal GDP during every economic downturn since 2008. A reason for this counter-cyclicality in China’s consumption is that the monthly retail sales data consists of household, government and business purchases.  Since the Chinese government tends to increase its expenditures during economic downturns, the increases in government purchases help to offset the declines in household and business consumption. Chart 3Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Chart 4China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus A more important contributor to the faster retail sales growth during economic down cycles is government stimulus. Direct pro-consumption policies, such as sales tax cuts and subsidies, helped to boost auto sales in every cycle since 2008, whereas stimulus measures to enhance home sales indirectly led to an upcycle in the sales of home appliances in 2015-2016 (Chart 4).  April’s retail sales data showed a sharp rebound in Chinese household consumption in autos, appliances and furniture (Chart 5). The strong comeback in durable goods purchases in April was driven by a release of pent-up demand and government pro-consumption measures. Since March, local governments have handed out subsidies, vouchers and tax reductions on consumer durable goods purchases and discretionary spending, such as travel and restaurant dining. By end-April, an estimate of 40 billion yuan worth of consumption vouchers were issued by provincial and city-level governments, with more than 90 percent of them targeted at discretionary goods and services. We think the government will announce further policies to support consumption at the May 22-23 National People’s Congress.  Chart 5A Strong Comeback In Durable Goods Sales A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chinese consumers took on more medium- and long-term loans in March and April, indicating a renewed appetite for purchasing real assets and durable goods (Chart 6). This is partially because consumers want to take advantage of lower interest rates and easier monetary conditions. Moreover, Chinese households may also be seeking real assets to hedge future inflation and financial market uncertainties. Housing in China in the past two decades has been perceived as countercyclical and a low-risk asset that holds value. Early signs indicate a renewed Chinese consumers’ appetite for real assets and durable goods. Both land sales and real estate investment growth returned to positive territory in April, while the contraction in floor space started, completed, and sold all narrowed. The upward cycle in the property market should continue to support a recovery in household appliances and furniture (Chart 7).   Chart 6Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Chart 7A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales In addition, global travel restrictions will likely remain in place through this year. This may prompt Chinese consumers to allocate a larger portion of their discretionary spending budgets to domestic, high-end consumer goods and services. Bottom Line: Early signs indicate a renewed consumer appetite for real assets and durable goods. The government’s pro-consumption and pro-growth measures should further boost discretionary spending. The Wealth Effect The consumption behavior of Chinese households will likely be driven by both the change in the value of their assets, and their expectations of the immediate or perceived future loss of employment and income. Housing is the largest part of Chinese households’ net worth.1 At the same time, financial assets account for a much lower share of Chinese households’ net worth versus their American peers.2 Home prices are much less volatile than stock prices, and we expect home prices in China to grow faster this year than in 2019. Hence the wealth effect of housing on Chinese consumers should remain positive. The unemployment rate has been elevated, but job losses so far are concentrated in the labor-intensive, lower-skilled manufacturing and service sectors (Chart 8). While lower-income workers account for more than half of China’s total population, their share of the country’s total household wealth and income is dismal compared with households in the top 10 percentile earnings3  (Chart 9). In fact, households in the bottom 40 percentile essentially have no discretionary spending capacity.4 Households in the top 40 group (middle- and upper middle-class urbanites) are the main driver of China’s discretionary and luxury goods market.5 Chart 8Job Losses So Far Concentrated In Lower-Skilled, Lower-Wage Manufacturing & Service Sectors A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chart 9Higher-Income Chinese Households Will Drive Recovery In Discretionary Consumption A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Because poorer households tend to have a higher marginal propensity to consume than the richer ones, China’s high income inequality may reduce the aggregate demand and has the potential to structurally stagnate its household consumption growth. This is a topic we hope to provide insights on in our future research. Cyclically, however, accommodative monetary conditions and outsized stimulus during economic downturns often help augment richer households’ net worth as well as increase their discretionary purchasing power. Our constructive view on China’s discretionary consumption could change if a second wave of Covid-19 infections is virulent enough to trigger another round of global lockdowns. In this case unemployment may expand from lower-income to middle-class Chinese consumers and extend from temporary to permanent job losses.  Consumption will also be constrained by more widespread income declines and renewed physical lockdowns.  Bottom Line: Job losses are concentrated in the lower-income household group so far. While developments in the pandemic remain fluid, our baseline view suggests that the wealth effect will have a limited impact on Chinese middle-class consumers. Investment Conclusions The recovery is still in its early stages, but government stimulus is bearing fruit in discretionary consumption. Furthermore, the elevated unemployment rate should prompt the government to roll out more consumption and growth-supporting measures at this week’s NPC conference, which will help further boost Chinese consumers’ appetite for discretionary spending.  China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries. China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries (Chart 10). The overwhelming shares of China’s online tech titans in the investable market, such as Alibaba and JD, make a strong case to overweight the consumer discretionary sector given that both online platforms will continue to benefit from the Chinese government’s pro-consumption schemes. On the other hand, the behavior of consumer discretionary versus consumer staples in China’s A-share market has been atypical.  Chart 11 shows domestic consumer discretionary stocks have consistently underperformed consumer staples since 2015, even during the 2016/2017 upcycle in broad market stock prices. We think a few underlying factors may be at play: Chart 10The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... Chart 11...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market Food and beverage companies in mainland China have one of the highest ROAs and the lowest financial leverages, which is preferred by Chinese domestic investors; Chinese liquor brands such as Kweichow Moutai and Wuliangye, which are listed on the A-share market and within the consumer staples group, have become collectable luxury goods. They have helped driving up the prices of consumer staple equities (Chart 12);  Soaring food prices since 2017 have helped to widen profit margins among food processing firms (Chart 13).   Chart 12Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Chart 13Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor For investors with a time horizon longer than a 12 months, consumer discretionary sector is a winner. However, for investors with a time horizon longer than 12 months, average returns in consumer discretionary stocks still beat staples in the past three market recoveries (Table 1). This is true for both onshore and offshore markets. As such, we recommend investors go long on consumer discretionary versus consumer staples in the investable market, and also go long on domestic consumer discretionary versus the broad domestic market. We are initiating these two trades today. Table 1CD Sector Still A Winner On A 12-18 Month Horizon A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Housing accounts for 59.1% in Chinese households’ net worth, compared with 30% in the US. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 220.4% of Chinese households’ total net worth is in financial assets. In the US, the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 3China’s low-income households account for about 60% of China’s population as of 2015. “How well-off is China’s middle class?” Center For Strategy & International Studies. https://chinapower.csis.org/china-middle-class/ 4 “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 5China Consumer Report 2020, McKinsey & Company, December 2019 Cyclical Investment Stance Equity Sector Recommendations

The South Korean economy is facing strong deflationary pressures, requiring significant and additional rate cuts. Meanwhile, 10-year government bonds yield are still at 1.4%, 75 basis points over 10-year US Treasurys (Chart II-1). Hence, Korea’s bond yields offer good value for fixed-income investors and have considerable downside. We have been receiving 10-year swap rates in Korea since 2011 and are reiterating this recommendation: Chart II-2 shows that the GDP deflator has been negative since 2018, and core and trimmed mean consumer prices are flirting with deflation. Chart II-1Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Chart II-2The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation   Falling prices amid elevated corporate and household debt levels – at 102% and 96% of GDP respectively – is toxic. The basis is price deflation increases real debt burdens. Notably, the debt service ratio for businesses and households is very high at 19.9% of GDP. Exports – which account for some 40% of GDP – are plunging. The business survey from Bank of Korea suggests exporters’ business sentiment plunged by a record in May and is close to 2008 levels, pointing to a dreadful export outlook. (Chart II-3) Domestic demand will remain weak, despite the large fiscal response to the COVID-19 outbreak. Business investment and hiring will be depressed for a while, undercutting consumer spending (Chart II-4). Chart II-3Exports In Freefall Exports In Freefall Exports In Freefall Chart II-4Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook   Finally, residential investment was in the doldrums even before the COVID-19 outbreak. Chart II-5 illustrates that declining residential construction permits preclude lower residential construction for the rest of the year. The Bank of Korea will have to cut interest rates considerably this year. From a big-picture perspective, there is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Korea’s economy shares many similarities with advanced economies like high debt levels and persistent deflationary pressures. On top of this, Korea is much more exposed to global trade, which makes its cyclical outlook worse, heralding substantial monetary easing. Exchange Rate Low interest rates could undermine the Korean won, even though the exchange rate has not historically been driven by interest rate differentials. The key driver of the won – shrinking global trade volumes and deflating tradable goods prices – warrants a cheaper currency to mitigate the negative impact on corporate profitability (Chart II-6). Chart II-5Falling Residential Construction Permits Falling Residential Construction Permits Falling Residential Construction Permits Chart II-6Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation   Besides, deflation in DRAM prices (Chart II-7) as well as DRAM sales point to further currency depreciation and lower Korean tech stock prices (Chart II-8). Chart II-7Deflating Semiconductor Prices... Deflating Semiconductor Prices... Deflating Semiconductor Prices... Chart II-8Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks     Overall, a weak currency is needed to alleviate deflationary pressures currently present in the economy. Stocks We are negative on the KOSPI in absolute terms but continue to recommend that EM-dedicated equity portfolio investors overweight this bourse. Despite being a highly cyclical market, we believe the KOSPI’s outperformance will be due to its large weight in tech stocks. The latter will benefit from China’s ambitious tech-related infrastructure plan in the coming years. The plan includes construction of Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet and data centers. We expect total investment will reach between US$182 billion and $266 billion by the end of 2020, an increase of 30-50% over last year. Importantly, 40% of Korea’s semiconductor exports are purchased by China. We have been playing the semiconductor theme via Korea rather than Taiwan because the latter is a wild card amid escalating geopolitical tensions between the US and China. Our geopolitical team expects a flare up in US-China tensions ahead of US elections this year, and Taiwan could become one of the focal points. Bottom Line: Continue receiving 10-year swap rates, shorting the won against the US dollar and overweighting the KOSPI within an EM dedicated equity portfolio. Lin Xiang, CFA Research Analyst linx@bcaresearch.com

Feature Analysis on Korea & South Africa are available on pages 6 and 10, respectively. Mexico: Balancing Pros And Cons We have been overweight Mexican sovereign credit and local currency bonds as well as equities relative to the respective EM benchmarks. Our rationale for this stance has been the fact that Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. However, the COVID-19 outbreak has introduced new dimensions into this analysis. On one hand, there are a number of positives that still warrant a lower macro risk premium on Mexican assets: The nation’s public debt burden is rising sharply but is not yet at an unsustainable level. We estimate that assuming (1) a nominal GDP contraction of 7% in 2020, (2) an overall fiscal deficit of 4.7% of GDP this year, and (3) the peso’s exchange rate versus the US dollar at 26, the gross public debt-to-GDP ratio will rise to 49% from 37% currently (Table I-1). If we assume the government takes over all SOE debt, including that of Pemex, total gross public debt will rise to 62% of GDP (Table I-1). While non-trivial, Mexico’s public debt burden is considerably lower than those in large EM countries like Brazil and South Africa. Table I-1Mexico's Public Debt Burden Mexico, Korea & South Africa Mexico, Korea & South Africa Chart I-1Mexico: Real And Nominal Rates Are Too High Mexico: Real And Nominal Rates Are Too High Mexico: Real And Nominal Rates Are Too High Despite widespread investor concerns, President AMLO has been running a very tight fiscal policy. At the end of 2019, the government had a primary surplus of 1% of GDP, and the overall deficit stood at 1.6%. In fact, given AMLO’s ideological approach to fiscal frugality, his government’s fiscal response to the COVID-19 pandemic to date has actually been less than what it can or should be. Similarly, monetary policy has been very tight. This is positive for creditors but negative for growth. The central bank has erred on the hawkish side and has a lot of room to reduce interest rates. Nominal and real interest rates in Mexico are among the highest in the EM universe (Chart I-1). Very tight fiscal policy means that monetary policy can be relaxed considerably. Interest rates in Mexico have a lot of downside.   Finally, the peso is reasonably cheap, according to the real effective exchange rate based on CPI and PPI measures (Chart I-2). Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. On the other hand, there are considerable negatives, especially regarding the growth outlook: A year and a half into his mandate, president AMLO has not been able to secure the corporate sector’s confidence in his administration’s policies. The government was attempting to reverse this trend in the months leading up to the COVID-19 outbreak by announcing a public-private infrastructure package and improving relations with the US. Nevertheless, the decision to shun large corporations from the national fiscal response has once again weighed on business confidence. This will further reduce capital spending and hiring, prolonging the recession (Chart I-3). Chart I-2The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap Chart I-3Business Confidence Plummets Again Business Confidence Plummets Again Business Confidence Plummets Again   The government’s fiscal response to the COVID-19 pandemic has been insufficient. The central government announced measures to increase funding for social and infrastructure programs and loans for households as well as small and medium businesses, amounting to a mere 3% of GDP. This is one of the lowest stimulus packages among major economies worldwide (Chart I-4). Chart I-4Mexico's Fiscal Response Is Poor Mexico, Korea & South Africa Mexico, Korea & South Africa Mexico is highly levered to the US economy. A deep contraction in American demand for consumer discretionary goods and international travel will suffocate Mexico’s export revenues. Exports of automobiles and tourism revenues together account for 37% of total goods and services exports, and 13% of GDP (Chart I-5). Balancing pros and cons, we recommend the following strategy for Mexican markets: Continue to overweight local currency bonds and sovereign credit within their respective EM benchmarks (Chart I-6). Orthodox fiscal and monetary policies warrant an overweight stance on fixed-income plays. Chart I-5Autos And Tourism Revenues Are Significant Autos And Tourism Revenues Are Significant Autos And Tourism Revenues Are Significant Chart I-6Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit   We reiterate our trade to receive Mexican 10-year swap rates. The only reason we are reluctant to be long cash domestic bonds is the potential for further currency depreciation. Finally, we are maintaining an overweight stance on equities, even though we acknowledge the very bad profit outlook. However, historically whenever Mexican interest rates have fallen relative to EM, Mexican stocks have typically outperformed the EM equity benchmark (Chart I-7). This is the primary rationale behind our equity overweight stance. Chart I-7Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices   Juan Egaña Research Associate juane@bcaresearch.com   South Korea: Bonds Offer Value Amid Looming Deflation The South Korean economy is facing strong deflationary pressures, requiring significant and additional rate cuts. Meanwhile, 10-year government bonds yield are still at 1.4%, 75 basis points over 10-year US Treasurys (Chart II-1). Hence, Korea’s bond yields offer good value for fixed-income investors and have considerable downside. We have been receiving 10-year swap rates in Korea since 2011 and are reiterating this recommendation: Chart II-2 shows that the GDP deflator has been negative since 2018, and core and trimmed mean consumer prices are flirting with deflation. Chart II-1Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Chart II-2The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation   Falling prices amid elevated corporate and household debt levels – at 102% and 96% of GDP respectively – is toxic. The basis is price deflation increases real debt burdens. Notably, the debt service ratio for businesses and households is very high at 19.9% of GDP. There is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Exports – which account for some 40% of GDP – are plunging. The business survey from Bank of Korea suggests exporters’ business sentiment plunged by a record in May and is close to 2008 levels, pointing to a dreadful export outlook. (Chart II-3) Domestic demand will remain weak, despite the large fiscal response to the COVID-19 outbreak. Business investment and hiring will be depressed for a while, undercutting consumer spending (Chart II-4). Chart II-3Exports In Freefall Exports In Freefall Exports In Freefall Chart II-4Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook Chart II-5Falling Residential Construction Permits Falling Residential Construction Permits Falling Residential Construction Permits Finally, residential investment was in the doldrums even before the COVID-19 outbreak. Chart II-5 illustrates that declining residential construction permits preclude lower residential construction for the rest of the year. The Bank of Korea will have to cut interest rates considerably this year. From a big-picture perspective, there is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Korea’s economy shares many similarities with advanced economies like high debt levels and persistent deflationary pressures. On top of this, Korea is much more exposed to global trade, which makes its cyclical outlook worse, heralding substantial monetary easing. Exchange Rate Low interest rates could undermine the Korean won, even though the exchange rate has not historically been driven by interest rate differentials. The key driver of the won – shrinking global trade volumes and deflating tradable goods prices – warrants a cheaper currency to mitigate the negative impact on corporate profitability (Chart II-6). Chart II-6Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation Chart II-7Deflating Semiconductor Prices... Deflating Semiconductor Prices... Deflating Semiconductor Prices...   Besides, deflation in DRAM prices (Chart II-7) as well as DRAM sales point to further currency depreciation and lower Korean tech stock prices (Chart II-8). Chart II-8...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Overall, a weak currency is needed to alleviate deflationary pressures currently present in the economy. Stocks We are negative on the KOSPI in absolute terms but continue to recommend that EM-dedicated equity portfolio investors overweight this bourse. Despite being a highly cyclical market, we believe the KOSPI’s outperformance will be due to its large weight in tech stocks. The latter will benefit from China’s ambitious tech-related infrastructure plan in the coming years. The plan includes construction of Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet and data centers. We expect total investment will reach between US$182 billion and $266 billion by the end of 2020, an increase of 30-50% over last year. Importantly, 40% of Korea’s semiconductor exports are purchased by China. We have been playing the semiconductor theme via Korea rather than Taiwan because the latter is a wild card amid escalating geopolitical tensions between the US and China. Our geopolitical team expects a flare up in US-China tensions ahead of US elections this year, and Taiwan could become one of the focal points. Bottom Line: Continue receiving 10-year swap rates, shorting the won against the US dollar and overweighting the KOSPI within an EM dedicated equity portfolio. Lin Xiang, CFA Research Analyst linx@bcaresearch.com South Africa: A Point Of No Return On Public Debt South Africa’s public debt is bound to surge to unsustainable levels: from 62% of GDP in 2019 to 95% of GDP by the end of 2021. If the government is forced to take over unsustainable debt from state-owned enterprises, which is very likely, it will push up the public debt-to-GDP ratio further by another nine percentage points to 104% of GDP. Table III-1 summarizes South Africa’s public debt projections using the following parameters and assumptions: To fight the COVID-19-induced economic crunch, President Cyril Ramaphosa recently announced a fiscal stimulus package of $26 billion (R500 billion), or 10% of GDP. Using recent government and central bank projections for 2020 and 2021, nominal GDP growth is expected to contract by 2.5% and expand 6.7%, respectively. Notably, fiscal revenue growth is expected to fall by 32% in nominal terms, according to recent comments by the Minister of Finance.1  Meanwhile, government spending will grow by 15%,2 and the primary fiscal deficit is expected to widen to 15.4% of GDP in 2020. Given that government forecasts often tend to be optimistic, chances are that both the primary deficit and public debt-to-GDP ratio will overshoot these forecasts. Finally, the sharp drop in domestic demand will increase the odds of a default among state-owned enterprises, with Eskom likely being a case in point. Current government guidelines require at least two thirds of Eskom’s R450 billion debt to be transferred to government balances in the event of default or anticipated default. In such a case, this increases the government debt-to-GDP ratio by an additional R350 billion, or 7% of GDP. Table III-1Projections For South Africa Fiscal Position And Public Debt Mexico, Korea & South Africa Mexico, Korea & South Africa Altogether, the public debt-to-GDP ratio will surge to 104% of GDP by the end of 2021 (Chart III-1). With public debt above 100% of GDP, interest rates well above nominal GDP and the government running large primary deficits, debt dynamics will become unsustainable. To avoid a public debt crisis, the government should either run large primary surpluses, which is unfeasible anytime soon, or bring down government borrowing costs to push up nominal GDP above interest rates (Chart III-2). Chart III-1Public Debt-To-GDP Will Balloon To 104%! Public Debt-To-GDP Will Balloon To 104%! Public Debt-To-GDP Will Balloon To 104%! Chart III-2Unsustainable Gap Between Local Yields And Nominal Growth Unsustainable Gap Between Local Yields And Nominal Growth Unsustainable Gap Between Local Yields And Nominal Growth   The latter option is the only one that is politically feasible. But to do so, the central bank needs to resort to the monetization of public debt. The central bank (SARB) has already taken the first step to bring down bond yields by buying government bonds in the secondary market. While the rationale of that was to cover foreign investors’ selling of local currency bonds, it amounts to nothing else but quantitative easing, or public debt monetization. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. As such, debt monetization is a fait accompli in South Africa. Monetizing part of the government’s debt will help reduce real borrowing costs and at the same time reflate nominal GDP growth, thereby boosting government revenues. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. If foreigners continue to sell the local currency bond market, the SARB and commercial banks will need to buy more government debt, creating even more money. This is why we expect the rand to continue depreciating. Investment Recommendations Chart III-3The Rand Could Drop Further Given Public Debt Dynamics The Rand Could Drop Further Given Public Debt Dynamics The Rand Could Drop Further Given Public Debt Dynamics The currency will likely get cheaper provided the rising odds of outright public debt monetization (Chart III-3). Continue shorting the rand versus the US dollar. We are initiating a new position of receiving 2-year swap rates. Odds are that the central bank will cut rates further in the months to come. Remain underweight local currency bonds in an EM-dedicated portfolio. Even though local domestic rates will likely fall, South African bonds will not outperform the EM benchmark on a total return in US dollar basis, mostly due to chronic currency depreciation. Finally, investors should underweight sovereign credit (government US dollar bonds) due to the unsustainable public debt dynamics. Dedicated EM equity portfolio investors should maintain a below-benchmark allocation to this bourse. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     The Minister of Finance made remarks about tax revenue falling by 32% in nominal terms. Tax revenues represent almost 100% of overall revenue. 2     Overall fiscal package is estimated to be 3% of GDP. This excludes reprioritization in 2020 around R130 billion & loan guarantee scheme of R200 billion. Overall total additional spending amounts to R170 billion in 2020 fiscal year. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest Pickup In M1 Still Modest Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2 Recovery To Gain Traction In H2 Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up #WWIII #WWIII Chart 2The Thucydides Trap The Thucydides Trap The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce The Great Economic Divorce The Great Economic Divorce Chart 4Decoupling Is Empirical Decoupling Is Empirical Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be ... But Tariffs Can And Will Be ... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US A Measure Of Inequality In The US A Measure Of Inequality In The US Chart 9US Nationalism On The Rise #WWIII #WWIII Chart 10Broad-Based Anti-China Sentiment In US #WWIII #WWIII As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite #WWIII #WWIII Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity #WWIII #WWIII Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Ever since the Federal Reserve’s liquidity injections, the dollar has been trading in a bifurcated manner. Historically, this has been a rare event. The main bifurcation has been between developed market and commodity/emerging market currencies. Stability in the USD/CNY exchange rate is a key indicator to watch. Movements in this cross will indicate where the balance of forces are shifting. Feature Chart I-1A Tale Of Two Dollars A Tale Of Two Dollars A Tale Of Two Dollars The Federal Reserve’s dollar liquidity injections have been massive, but two dollars continue to fight a tug of war. The first is the DXY index, which has largely surrendered to the flood of liquidity offered through the Fed’s swap lines and temporary FIMA repo facility. In fact, cross-currency basis swaps in both Japan and the euro area, a measure of offshore dollar funding stress, have eased. As a result, volatility in the DXY index has been crushed, keeping it largely below the psychological 100 level. However, on the other side of the liquidity battle front have been emerging market and commodity currencies, some of which continue to make fresh lows. Remarkably, these have included currencies such as the Brazilian real that also have swap agreements with the US. In short, a rare divergence has opened up between two dollars (Chart I-1). Historically, whenever this has occurred, either the DXY index was on the verge of making new highs, or procyclical currencies were very close to a bottom. In our April 3rd report, we suggested three reasons as to why the dollar could remain well bid in the near term.1 In this report, we explore these reasons further and offer one variable to watch as the key arbiter between the two – the USD/CNY exchange rate. A Tale Of Two Dollars The bifurcated dollar performance has been underpinned by three factors. The 14 developed and emerging market currencies that have swap lines with the Fed2 all bottomed around March 19, when the funding announcement was made. These include currencies of countries that were initially excluded from a prior swap agreement such as Australia, Norway and New Zealand. The exception to this rule has been the Brazilian real. By extension, some currencies currently excluded from the swap agreement such as the Turkish lira and South African rand remain in freefall. The temporary repo facility for foreign and international monetary authorities (FIMA), which allows FIMA account holders to temporarily exchange their Treasury securities held with the Fed for US dollars, has instilled confidence. As such, this has assuaged selling pressure on currencies with ample dollar foreign exchange reserves. However, some currencies with low reserves such as the South African rand or Turkish lira continue to face downside risks. A huge portion of offshore dollar funding has been financed by non-bank entities. Not only does a rising dollar lift the debt burden of borrowers, but it also raises solvency risk for these concerns. Notably, non-banks have limited access to central bank swap lines. Of the US$12 trillion in dollar-denominated foreign debt outstanding, 32% is from emerging markets, a share that has increased massively since the financial crisis (Chart I-2). This might explain why currencies like the Brazilian real, exposed to significant foreign-currency corporate debt obligations, continue to see selling pressure, despite the Fed facilities in place (Chart I-3). Chart I-2Rising EM Dollar Debt Rising EM Dollar Debt Rising EM Dollar Debt Chart I-3Some EM Have High External Debt Some EM Have High External Debt Some EM Have High External Debt In short, with the Fed and many other developed-market central banks engaged in active purchases of corporate paper, a line in the sand has been drawn between currencies where the lenders of last resort have stepped in, and others where their central banks are still unwilling to take credit risk. Put another way, certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback. Unfortunately, there is nothing the Fed can do about this. Dollar liquidity shortages tend to be vicious because they trigger negative feedback loops. As offshore dollar rates among non-banks begin to rise, this lifts the cost of capital for borrowing entities, with debt repayment replacing capital spending. This is where China can step in. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.1 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The important distinction from foreign exchange reserves is that swap agreements entail no exchange of currency. As such, it is about confidence. With low external debt and massive FX reserves, the PBoC can instill this confidence in countries that have low and/or falling foreign exchange reserves.  Certain currency markets are starting to price USD solvency risk, resulting from the broad shutdown in their economies and the rise in the greenback.  There has been a precedent to this. Since the global financial crisis, as the PBoC has been engaging in powerful monetary stimulus, the number of bilateral swap lines offered to foreign central banks has also ballooned. Bloomberg no longer publishes swap data for the PBoC, but a recent article suggests that as recent as 2018, the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 38 countries and regions, with a total amount of around 3.7 trillion yuan (Chart I-4).3 Remarkably, this excluded the US Fed. This means that the USD/CNY exchange rate will become a key arbiter of the divergence between the two dollars. If Asian and Latin American currencies can stabilize versus the RMB and the USD/CNY exchange rate can remain stable, then an informal accord has been established. So far, the RMB appears the arbiter between these two dollars (Chart I-5). Chart I-4Chinese Swaps To The Rescue? Chinese Swaps To The Rescue? Chinese Swaps To The Rescue? Chart I-5USD/CNY As A Dollar Arbiter USD/CNY As A Dollar Arbiter USD/CNY As A Dollar Arbiter We understand that geopolitical tensions between the US and China are escalating, and so the probability of such an event – if global growth rebounds earnestly – is low. However, should global growth remain weak, a fall in the RMB will highlight the PBoC is actively using its currency as a weapon. This will suggest all bets are off. Bottom Line: Developed market commodity currencies have a correlation of almost parity with EM FX (Chart I-6). An explicit swap agreement between China and emerging market countries could be the key to assuage dollar funding pressures within emerging markets. This will ease the selling pressure on developed-market commodity currencies. Chart I-6The Risk To Commodity Currencies The Risk To Commodity Currencies The Risk To Commodity Currencies Market Signals And Signposts Ever since Richard Nixon severed the gold-dollar link in the early ‘70s, there have been three major episodes when some currencies bucked the broad dollar trend. Historically, this has been driven by two major factors (Table I-1):4 Table I-1Summary Of Currency Divergence Episodes Line In The Sand Line In The Sand De-synchronized global growth A localized debt/economic crisis The first episode occurred in the early 1990s. As the world was exiting a recession in part triggered by tight US monetary policies, lower US interest rates allowed the dollar to fall along with rising global growth. Only the yen, on the back of an economy entering into a debt deflation spiral (where positive real rates begot more currency appreciation), was able to buck this trend. Developed market commodity currencies have a correlation of almost parity with EM FX. The late 1990s saw the capitulation of Asian currencies. As a safe haven, the US dollar started to benefit from repatriation flows. Asean and commodity currencies were under intense selling pressure from pegged exchange rates and a long period of low interest rates that had generated massive imbalances. Remarkably, the euro was the area of shelter..  The world in 2005-2006 was entering a full-blown mania. Procyclical currencies were benefitting from Chinese industrialization and the creation of the euro. Meanwhile, Japan continued to sag under a mountain of debt. This pushed market participants to increasingly use the yen as a funding currency for carry trades, allowing it to depreciate versus the US dollar. Enter 2020. The world today is in a synchronized slowdown, but varying degrees of policy measures suggest we could continue to see a lack of synchronicity in dollar trading over the near term: The euro area appears poised to recover faster than the US in the near term (Chart I-7). If this proves correct, any knee-jerk selloffs in the euro should be bought. This is directly linked to the speed at which European economies reopen, relative to the US. By extension, Asian currencies should do better than those in Latin America. Conclusion: the dollar could fall against the euro, but rise against some emerging market currencies. The easiest way to express this view is to buy the cheapest European currencies, such as the Norwegian krone and Swedish krona. We are long both. The yen, typically used as a funding currency, will be hostage to a sudden stop in funding flows. This is because there is no interest rate advantage anymore between Japanese and US paper, once accounting for hedging costs (Chart I-8). This suggests carry trades in developed markets, using the Japanese yen, are stuck in the barn for now. Meanwhile, as a safe haven currency, the yen will still benefit from a rise in FX volatility. Short USD/JPY hedges make sense. Chart I-7Euro Area Versus##br## US Growth Euro Area Versus US Growth Euro Area Versus US Growth Chart I-8The Yen Is No Longer An Attractive Funding Currency The Yen Is No Longer An Attractive Funding Currency The Yen Is No Longer An Attractive Funding Currency Commodity and emerging market FX will be the outlier against the US dollar for now. These continue to face downward pressure in the near term. In terms of commodities, the sudden stop in demand has been met with an overwhelmingly slow response to curtail supply. Eventually, higher demand will benefit these currencies, but the supply story dominates for now in crude oil and industrial commodities. That said, this week’s rise in Chinese commodity imports was encouraging. Stay tuned.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Capitulation?,” dated April 3, 2020, available at fes.bcaresearch.com. 2 These include the Bank Of Canada, Bank Of Japan, Bank Of England, European Central Bank, the Swiss National Bank, the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank. 3 Please see The History Of Commerce, China. 4 Please see Foreign Exchange Strategy Special Report, titled “Can There Be More Than One US Dollar”, dated June 08, 2018, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been negative: The Markit manufacturing PMI fell to 36.1 in April; the services PMI also slipped to 26.7. ISM manufacturing PMI dropped to 41.5 and non-manufacturing PMI declined to 41.8. The trade deficit widened from $39.8 billion to $44.4 billion in March. Unit labor costs increased by 4.8% quarterly in Q1, while nonfarm productivity fell by 2.5%. Initial jobless claims continued to grow by 3169K last week. The DXY index surged by 1.5% this week. The Senior Loan Officer Survey released this week reported an increasing net percentage of domestic banks tightening standards for most loan types in Q1, including C&I, auto and mortgage loans. On Tuesday, the Fed’s Raphael Bostic said that there are great uncertainties around “V-shape” recovery. Report Links: Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 Are Competitive Devaluations Next? - March 6, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been negative: The Markit manufacturing PMI fell further from 33.6 to 33.4 in April, while the services PMI stayed low at 12. Sentix investor confidence remained low at -41.8 in May. Retail sales contracted by 9.2% year-on-year in March, compared to a 3% increase the previous month.  The euro declined by 0.8% against the US dollar this week. The German court has criticized the ECB bond-buying programme, warning that the ECB’s purchases could be illegal under German law unless the ECB can prove otherwise. Continuing conflicts among Eurozone members and imbalances between countries could add more pressure on the ECB. In addition, the European Commission forecasts the euro zone economy to contract by a record 7.7% this year. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been negative: The manufacturing PMI fell from 43.7 to 41.9 in April. Vehicle sales kept contracting by 25.5% year-on-year in April, following a decline of 10.2% in March. Monetary base increased by 2.3% year-on-year in April, down from a 2.8% increase the previous month. The Japanese yen appreciated by 0.4% against the US dollar this week, despite broad US dollar strength. Since the beginning of the Fed swap lines operation this year, the BoJ has the highest liquidity swaps with the Fed, amounting to US$220 billion as of April 30, helping to ease dollar funding pressure in Japan. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mostly negative: The Markit manufacturing PMI fell further to 32.6 from 32.9 in April, while services PMI remained low at 13.4. Nationwide housing prices increased by 3.7% year-on-year in April, up from 3% the previous month. Money supply (M4) surged by 7.4% year-on-year in March. The British pound plunged by 2.7% against the US dollar this week. The Bank of England held interest rates unchanged on Thursday morning, while warning that the coronavirus crisis will push the UK economy into its deepest recession in 300 years. The Bank is now forecasting the output to slip by 3% in Q1, followed by a 2.5% plunge in Q2. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Building permits plunged by 4% month-on-month in March, down from 19.4% the previous month. Exports surged by 15.1% month-on-month while imports fell by 3.6% in March. The trade surplus expanded by A$6.8 billion to A$10.6 billion. The Australian dollar fell by 1.5% against the US dollar this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. More importantly, the Bank has scaled back the size and frequency of bond purchases, which so far totalled A$50 billion, while stating that they are prepared to scale-up the purchases again should conditions worsen. In addition, the RBA forecasts the output to fall by roughly 10% in the first half of 2020 and by 6% over the year, followed by a rebound of 6% next year. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits fell by 21.3% month-on-month in March, down from 5.7% increase in February. The unemployment rate ticked up from 4% to 4.2% in Q1, lower than the expected 4.4%. Employment increased by 0.7% quarter-on-quarter. The participation rate increased by 30 bps to 70.4%. In addition, wage rates increased by 2.5% annually. The New Zealand dollar dropped by 1.8% against the US dollar this week. While many may call the Q1 Labour Market Statistics a positive surprise, Statistics New Zealand has indicated that the March data from household labour force survey was interrupted due to the lockdown in March. In a typical quarter, around 25% of the interviews for this survey are carried out face-to-face. We expect the Q2 Labour Survey to show more clearly how the COVID-19 lockdown has changed New Zealand’s labour market. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI plunged from 46.1 to 33 in April. Both exports and imports fell notably in March: exports narrowed by C$2.3 billion to C$46.3 billion. Imports decreased by C$1.8 billion to C$47.7 billion. The trade deficit widened from C$0.9 billion to C$1.4 billion. Bloomberg Nanos confidence ticked up from 37.1 to 37.7 for the week ended May 1. The Canadian dollar fell by 0.9% against the US dollar this week. The decline in exports was led by auto manufacturing, aircraft, and energy products. Moreover, a depreciating Canadian dollar has largely impacted the trade values in March. When expressed in US dollar terms, export fall by 9.2% month-on-month and imports by 8.1%, which compares favourably with 4.7% decrease in exports and 3.5% decline in imports in Canadian dollars. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mostly negative: The manufacturing PMI fell from 43.7 to 40.7 in April, above the expectations of 34.6. Consumer climate plunged from -9.4 to -39.3 in Q2. Headline consumer prices fell by -1.1% year-on-year in April, down from -0.5% in March, also below the expectations of -0.8%.  The unemployment rate increased from 2.8% to 3.3% on a seasonally adjusted basis in April. The Swiss franc fell by 1% against the US dollar this week. With consumer prices decreasing for a third consecutive month, the SNB has stepped up the currency intervention. Total sight deposits have increased by nearly 77 billion CHF this year, compared to only 13.2 billion CHF in 2019 and 2.3 billion CHF in 2018. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There has been no significant data release from Norway this week. The Norwegian krone appreciated by 0.6% against the US dollar this week. On Thursday morning, the Norges Bank delivered a surprise rate cut by 25 bps to a record low of 0 due to the severity of the coronavirus and huge decline in oil prices. However, they also implied that further cuts into negative territory are unlikely. In addition, Governor Øystein Olsen said that they expect the output to drop by roughly 5% this year, a decline of a magnitude that has not been seen since World War II. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Manufacturing PMI fell from 42.6 to 36.7 in April. Industrial production fell by 0.1% year-on-year in March. Manufacturing new orders contracted by 2% year-on-year in March, down from 5.7% increase in February. The Swedish krona has been more or less flat against the US dollar this week. Like the ECB, the Riksbank might have some legal issues regarding its bond purchases program. The current Riksbank Act does not allow the bank to make outright purchases of corporate bonds or other private securities on the primary or secondary markets. So far, the Riksbank has purchased 5.6 billion SEK of corporate commercial papers to support the economy under the COVID-19. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades