China

Highlights The rising policy rate in the past couple months has been driven by a liquidity crunch, which is expected to ease in Q4. Government bond yields, which have been trending upwards since May, will also take a breather. The extremely accommodative phase of monetary conditions has ended. Monetary policy will be tightened, possibly by the middle of next year. We expect the yield curve to move broadly sideways in Q4 and into early 2021. As early as Q2 next year, a rebound in rate hike expectations will cause the curve to flatten. We remain overweight on Chinese stocks over the next six to nine months. Beyond that, a more restrictive monetary policy and less buoyant economic outlook may warrant a trimming of positions in Chinese stocks. Feature Chinese government bond yields have rebounded sharply since bottoming in late April; 10-year yields have climbed by 62 basis points to 3.1% as we go to press. Given that the 3-month SHIBOR (the PBoC’s de facto policy rate) has gone up by 128 basis points from its nadir in April, the higher bond yields reflect policy-driven liquidity tightening. The economy’s quick turnaround following the reopening of business activities has prompted the authorities to normalize the monetary stance (Chart 1). China recently made more interbank liquidity injections to slow the speed of policy rate normalization. We think it is the right move. China’s economic recovery is still at an early stage and may not withstand a rapid tightening in monetary policy. Furthermore, the chances are low that the 3-month SHIBOR will rise above its pre-COVID-19 level of 3% in this calendar year. Yields on short-duration government bonds will have little room to move higher in 2020. China’s 10-year government bond yield may even drop slightly when geopolitical tensions between the US and China heat up as the US election nears. Chart 1Policy Rate Normalization Started In May Chart 2Rate Normalization Will Resume In 2021 As China’s economic recovery is expected to continue accelerating into the first half of 2021, interest rates will also resume their climb (Chart 2). Our base case view is that the first rate hike, which will lift the policy rate above its pre-COVID-19 level, will happen as early as Q2 next year but no later than mid-2021. This means that the cyclical bear market in the bond market will continue. A Temporary Easing In Q4… In our report published on February 19, we argued that the rally in Chinese government bonds in early 2020 would be short lived rather than a cyclical (6-12 month) play.1 Furthermore, a journey back to the pre-outbreak monetary stance would start as early as Q2 this year. Notably, Chinese policymakers have pivoted to normalize monetary policy from an ultra-loose stance linked to COVID-19. In our view, the speed of the rebound in the policy rate has run ahead of the economic recovery. In other words, the policy stance tightened before inflation expectations turned more optimistic (Chart 3). Retail sales growth barely turned positive in August from a year ago, core inflation has dropped to its lowest level since the Global Financial Crisis and producer prices are still contracting on an annual basis (Chart 4). Chart 3Policy Stance Tightened Before Inflation Moved Higher In the past two weeks, the PBoC has injected liquidity more frequently through open market operations, an indication that policymakers may be trying to slow the pace of tightening (Chart 5). Maintaining nominal GDP growth above 4% this year is politically imperative for the Communist Party to achieve its employment growth objective.2 This overarching goal will likely hold back the PBoC from easing off the gas too abruptly. Chart 4The Economy Is Still Growing Below The Trend Growth Liquidity conditions will continue to improve into Q4, moderating the rise in the 3-month SHIBOR. The liquidity crunch in the banking system since May was created by a massive government bond issuance and curbing of high-yield structured deposits. Government bond issuance has reached its peak this year and bond quotas will plummet in Q4, which will help ease liquidity shortages in the banking sector (Chart 6). In turn, demand for interbank liquidity should moderate as banks have fewer bond purchasing obligations, giving the 3-month SHIBOR some breathing room with or without the PBoC’s intervention. Chart 5The PBoC May Be Trying To Slow The Pace Of Its Rate Normalization A pause in the policy rate hike will limit any upside risks for yields on short-duration government bonds. Yields on 10-year bonds may even drop if tensions between the US and China escalate leading up to the November US election, and/or additional significant pandemic waves affect the global economy. Chart 6Liquidity Conditions Should Ease In Q4 Bottom Line: It is unlikely that China’s policy rate and the long-duration government bond yield will end the year above their pre-COVID-19 levels. …Followed By Decisive Rate Hikes In 2H21 There are good and rising odds that Chinese authorities will fully switch to a tightening mode in 2021. Barring any domestic resurgence in COVID-19 that could trigger lockdowns, the PBoC may resume policy rate hikes as early as Q2, and no later than mid-2021. Our reasoning is as follows: Chart 7The PBoC Has Been Consistent With Policy Reaction In Previous Recoveries Consistent policy reaction in previous recoveries. Our April 23 report showed how the PBoC has been consistent in normalizing its monetary policy following each of the past three economic and credit cycles.3 The central bank raised interest rates on average nine months following a bottom in the business cycle. The tightening of interest rates occurred even after the prolonged economic downturn and deep deflationary cycle in 2015/16. The structurally slowing rate of China’s economic growth since 2011 has not prevented the PBoC from cyclically raising its policy rate (Chart 7). When the output gap is closed in 1H21, the PBoC will gain enough confidence to push for higher interest rates. Property market is strong. The property market has been heating up on the back of falling bank lending rates, despite policymakers’ efforts to curb both property lending and purchases. New home sales surged by 40% in August, the highest year-over-year growth since the last housing boom in 2016. In particular, demand for the first- and second-tier cities have rebounded sharply (Chart 8). This trend will likely prompt policymakers to enact stronger and earlier policy responses by tightening the medium lending facility (MLF) rate, an anchor for the mortgage lending rate. The labor market is recovering. The employment sub-indexes in the official PMIs of late point to an improvement in both the manufacturing and non-manufacturing sectors (Chart 9). Additionally, by the end of June, the number of returned migrant workers reached 96% of last year’s level. At this rate, the labor market should return to its pre-COVID-19 level by early next year. Chart 8Property Market Is Heating Up Chart 9The Labor Market Is Recovering Inflation will probably accelerate next year. We expect the recovery in the labor market to drive up both wage income and core CPI next year. Higher oil and industrial metals prices should also lift producer prices (Chart 10). Higher interest rates may not be counterproductive to policymakers’ support for SMEs. This is due to the authorities’ “window guidance”, mandating banks to reduce the spread between the loan prime rate (LPR) and bank lending rates. As seen in the past five months, although the policy rate has been rising, average bank lending rates have fallen (Chart 11). Policymakers will likely continue hiking policy rate to curb financial and property market speculations, but at the same time still able to guide bank lending rates lower and target their support for SMEs. Chart 10Inflation Will Likely Accelerate Along With Economic Growth In 1H21 Chart 11Bank Lending Rates Have Been Trending Down Despite Rising Policy Rate Bottom Line: Odds are rising that the PBoC will continue to hike interest rates (short and medium-term) by the middle of next year. In turn, the rebound in Chinese government bond yields will resume early next year in the expectation of better economic conditions and policy tightening. Investment Conclusions The upward momentum in both the short and long-end of the yield curve will likely abate from now till year-end (Chart 12, top panel). As early as Q2 next year, however, a rebound in rate hike expectations will cause the curve to flatten. Historically, the yield curve has always moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation (Chart 12, bottom panel). Given the extremely dovish stance among central banks (the Fed in particular), the upside in rate hikes by PBoC will be capped. We expect a less than 30bps rise in long-term bond yields. Tighter monetary policy is bullish for the RMB. Nonetheless, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction. The CNY has appreciated against the USD by 5% since bottoming in May, and we doubt that there will be a meaningful upside in the RMB against the dollar leading up to the US election. Meanwhile, widening interest-rate differentials have further reduced the odds of any significant CNY/USD depreciation (Chart 13). Chart 12A Rebound In Rate Hike Expectations In 1H21 Will Flatten The Yield Curve Chart 13Limited Upside For The RMB Against USD And On Trade-Weighted Basis In this vein, the CNY/USD exchange rate will be dominated by broader dollar performance. Furthermore, it is highly unlikely that the PBoC will tolerate sharp, trade-weighted currency appreciations. A declining USD will also limit the upside in the trade-weighted RMB. The RMB may be less reflationary to businesses in China, but it will not become outright deflationary for the time being (Chart 13, middle and bottom panels). In terms of equities, we maintain our positive cyclical view on China's growth outlook. The PBoC will maintain its tightening bias, but this should not lead to major growth disappointments. We continue to expect Chinese domestic and investable equities to outperform in both absolute and relative terms, at least for the next six to nine months. Beyond the next six months, however, a more restrictive monetary policy should bring China’s economy closer to its trend growth in 2H21. Sectors such as technology and real estate, which benefit the most from easy liquidity conditions and strong economic growth, will be negatively and disproportionally impacted. Given their heavy weight in China’s investable equity market, we will probably trim our positions in investable stocks by the middle of next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see BCA Research China Investment Strategy Weekly Report, "Don’t Chase China’s Bond Yields Lower", dated February 19, 2020, available at cis.bcareseach.com. 2 Please see BCA Research China Investment Strategy Weekly Report, "Taking The Pulse Of The People’s Congress", dated May 28, 2020, available at cis.bcareseach.com. 3 Please see BCA Research China Investment Strategy Weekly Report, "Three Questions Following The Coronacrisis", dated April 23, 2020, available at cis.bcareseach.com. Cyclical Investment Stance Equity Sector Recommendations

Bank Credit Analyst

Highlights The global recovery has legs, but it will follow a stop-and-go pattern. Global fiscal policy will ultimately remain loose enough to create an appropriate counterweight to three major risks. Risk assets are still attractive on a 12-month investment horizon despite short-term dangers. The dollar cyclical downtrend will be tested, but it will prevail. 10-year Treasury yields will be range bound between 0.5% and 1%. Industrials, materials, gold and Japanese equities are attractive. Feature Chart I-1Ebbing Surprises The S&P 500 correction remains minimal in the face of Washington’s inability to reach a much-needed fiscal compromise. This resilience reflects that economies in the G-10 and China have pleasantly surprised investors despite rolling second waves of infections across the world, fiscal policy paralysis and generalized unease (Chart I-1). Strong growth has fueled higher earnings expectations. Meanwhile, global central banks are promising to keep accommodative monetary conditions in place indefinitely, which has allowed valuations to balloon. The cyclical outlook for stocks remains attractive. Nonetheless, global equities have entered a period of heightened volatility and downside risk until year-end. The S&P 500 had overshot its fundamentals, but now the momentum of the economic surprise index is deteriorating and central banks have deployed their full arsenal. Investors are concerned by a lack of fiscal support and rising policy uncertainty created by the approaching US election in November. This nervousness will spark powerful fluctuations in stock prices.  Avoid Binary Judgments The global economy is at a complex juncture, buffeted between forces that will either propel its recovery or sink it. The positives will predominate in this contest, which suggests that the business cycle remains in an upswing, albeit, a volatile one. The Good… Five main positive forces underpin the nascent economic bounce and thus, the profit outlook. Pent-up demand and the inventory cycle: The economy is making up for the collapse of both cyclical spending and production at the end of Q1 and into Q2. Inventories of finished products have sharply declined in the past six months. In the US, rapidly shrinking inventories are supercharging the uptick in the new-orders-to inventories ratio. Similar dynamics are occurring in China, Europe and Japan (Chart I-2). China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. The Chinese engine is revving: An aggressive stimulus campaign followed Beijing’s swift actions to contain the domestic spread of COVID-19. China’s policies are generating economic dividends that will percolate through the global industrial and commodity sectors. Sales of floor space are already expanding by 40% annually, driven by a 60% jump in Tier-1 cities. In response, construction is forming a trough. Moreover, the large issuance of local government bonds is financing an increase in infrastructure spending. Thanks to an upturn in building activity, the equipment purchases, construction and installation components of China’s real estate investment are all bottoming (Chart I-3). Chart I-2The Inventory Adjustment Is Advanced Chart I-3China: A Policy-Driven Recovery   BCA Research’s Emerging Markets team recently showed that the expenditure rebound is not limited to the real estate sector.1 Vehicle sales are healthier and tech infrastructure outlays are reaccelerating (Chart I-4). Retail sales also moved back into positive territory in August. Thus, China’s cyclical spending has regained its footing. China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. Beijing’s unconstrained credit easing is the source for the turnaround in China’s cyclical and capital expenditures outlook. Hence, the sharp increase in China’s credit and fiscal impulse foreshadows a powerful rebound in imports and in global industrial production because Chinese capex demands plentiful commodities, industrial goods and capital goods (Chart I-5).  Chart I-4More Chinese Recovery Chart I-5Chinese Stimulus Matters Globally   Chart I-6Robust American Households Consumer balance sheets are robust: Unlike the aftermath of the Great Financial Crisis (GFC), US households do not need to rebuild destroyed balance sheets. This time around, the low level of household debt and the limited hit to net worth has allowed consumers to withstand an even greater income shock than during the GFC (Chart I-6). As a result, expenditures are rebounding much quicker than most investors anticipated six months ago. An extremely vigorous policy response: Policymakers in the G-10 did not wait to deploy their economic arsenal when the economic crisis erupted. Governments have racked up their largest budget deficits since World War II (Chart I-7). Monetary authorities also moved quickly to ease financial conditions. Broad money supply growth among advanced economies has skyrocketed, global corporate bond issuance stands at a record $2.6 trillion, and excess liquidity points to continued industrial production strength. In the US, our Financial Liquidity Index is climbing higher alongside the ISM Manufacturing Index. Even the performance of EM carry trades (a financial variable that shows whether funds are flowing into EM economies) is consistent with a stabilization in global IP (Chart I-8). Chart I-7Exceptional Fiscal Stimulus Chart I-8Liquidity Helps Growth     Stronger industrial production models: Our industrial production models for the major advanced economies are all moving up after experiencing massive collapses this past spring. These models encapsulate many influences and their uniformly positive message is very encouraging. In all likelihood, a virtuous cycle has been unleashed. As IP recovers, then so will income, which will fuel the demand expansion and thus, more production. We expect the models to rise even more in the coming quarters. … And The Bad Three near-term concerns still hang over the global economy. Hence, while Q3 is set to deliver stunningly strong numbers boosted by advantageous base effects, growth will recede in Q4.2  While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. Fiscal stimulus hiccups in the US: While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. The CARES Act’s expanded $600 per week unemployment benefit lapsed at the end of July. This benefit, along with one-time $1200 stimulus checks, pushed disposable income higher by 7.5% during the past five months. Thankfully, households managed to save a large proportion of the government support. Consequently, consumption remained strong in August, despite limited help from the federal government. The short-term outlook for consumption is fragile because households cannot continue to tap into their savings. In August, US retail sales disappointed. Calculations by our US fixed-income strategist show that in the coming months, Washington must spend almost $800 billion just for consumer expenditures to match its growth rate of -3% recorded at the depth of the last recession.3 Moreover, a potential wave of eviction of renters looms. Thus, the economy could relapse violently as long as Democrats and Republicans remain apart on a compromise for a new stimulus bill. The upcoming Senate confirmation process to fill the Supreme Court seat left vacant by Ruth Bader-Ginsburg’s passing only complicates the passage of these needed spending measures. Chart I-9Permanent Joblessness Is A Threat Rising permanent job losses: The US unemployment rate has fallen from a high of 14.7% in April to 8.4% in August. This bright picture hides a negative development. The number of permanent job losses has quickly escalated, reaching 4.1 million last month (Chart I-9). Moreover, continuing unemployment insurance claims are barely declining. Mounting long-term unemployment is not associated with an economic recovery. Furthermore, permanent joblessness could easily push down consumer confidence, which would lift the household savings rate and hurt consumption. This problem is not unique to the US. In the UK, an unemployment cliff looms on October 31 when there will be an end to government schemes allowing firms to receive funds as long as they do not permanently severe their links with furloughed workers. The UK’s unemployment rate of only 4.1% is bound to surge when these support measures disappear. In continental Europe, similar stimulus programs could also be rescinded this fall. The weak health of small businesses accentuates risks to the labor market. In the US, 21% of very small firms will run out of money by the end of the year if the government does not dispense supplemental help. Closing these businesses will push up permanent joblessness even more and thus, further weaken consumption. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. COVID-19 and the service sector: Many major countries are now fighting a second wave of infections, which may surpass the first wave. Many schools have re-opened and winter in the Northern Hemisphere is approaching (which will force people to congregate inside), bringing with it the regular flu season. Chart I-10The Service Sector Is The Weakest Link This epidemiological backdrop still represents an elevated hurdle to overcome for large swaths of the service sector, especially leisure, food, hospitality and travel. While these industries account for only 10% of GDP in the US, they contribute roughly 25% of employment. If governments toughen social distancing rules and implement localized lockdowns, then the service sector will act as a drag on GDP and employment (Chart I-10). Which Side Will Win? Ultimately, we anticipate that the tailwinds supporting the economy will overcome the headwinds. On the policy front, governments will pass more stimulus. Our Geopolitical strategists believe that the following constraints will force greater spending in the US by mid-October: The Democrats face an election and they want to deliver benefits to their voters.  The White House needs to prevent financial turmoil in the final month of the campaign. If the Republicans fail to agree on a second stimulus bill, there is a significant risk they will lose the White House and their majority in the Senate. Chart I-11No Constraints There The package should total nearly $2 trillion. The Democrats have reduced their demands to $2.3 trillion, while the GOP has moved up its offer to $1.3 trillion. Moreover, a bi-partisan “Problem Solvers Caucus” has emerged in Congress with a $1.5 trillion bill proposal that the White House is considering. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. Fiscal stimulus will also remain generous outside the US. In Europe, France is providing an attractive template. On September 3, the Macron government announced an additional EUR100 billion stimulus package, whereby 40% of the funds would come from the common bond issuance recently announced by the EU. In Japan, Prime Minister Yoshihide Suga will continue the policies of his predecessor. Finally, in emerging economies, the absence of inflation and well-behaved sovereign yields and spreads have provided room for local authorities to alleviate any economic pain created by COVID-19 (Chart I-11). Monetary policy will remain extremely stimulative. Central banks will not meaningfully ease policy further, but our monetary indicators are already at their most accommodative levels on record (see Section III). Plus, the US Federal Reserve’s switch to an average-inflation target last month raised the bar that inflation must reach before the FOMC tightens policy. The European Central Bank is contemplating a similar change. Furthermore, the continued woes of service-sector employment constitute another hurdle to clear before central banks can remove accommodation. Chart I-12US Housing Is The New Locomotive Finally, COVID-19 currently has a limited impact on the lion’s share of cyclical spending, which will continue to recover. Cyclical sectors include residential investment, business capex and spending on consumer durable goods. In the US, they account for only 20% GDP, but they generate 70% of the variance in its fluctuations. These sectors are heavily geared toward manufacturing, which is crucial for cyclical spending. Importantly, the robustness of household balance sheets and record low borrowing costs have allowed mortgage applications for purchases to rise sharply, home sales to recover and homebuilder confidence to surge to an all-time high (Chart I-12). Hence, residential activity will remain an important driver of domestic demand, especially because residential investment also often galvanizes other forms of cyclical spending. Bottom Line: The global economy remains buffeted between five positive forces that bolster the recovery and three negatives that hamper it. Ultimately, the authorities will have no choice but to add supplementary fiscal stimulus and monetary conditions will remain extremely accommodative. The recovery will then slow from its heady Q3 pace, but cyclical spending will still power ahead next year. In a nutshell, the economy will not be weaker nor much stronger than the base case presented by the IMF. Investment Implications Our somewhat upbeat position on the global economic outlook remains consistent with a favorable stance toward risk assets in the next 12 to 18 months, because adverse economic outcomes are unlikely to materialize, not because growth will be stronger than expected. Nonetheless, we are conscious that the market place remains fraught with many risks and that growth will stay volatile. As a result, episodic violent corrections will punctuate the upward path in risk asset. We are currently in the midst of such a correction. Chart I-13The Dollar Remains Expensive The Dollar We are still bearish on the dollar on a cyclical investment horizon. The USD remains expensive despite its recent weakness. Against major currencies, the dollar has climbed by 30% since 2008. On a broad, trade-weighted basis, it is up 36% in the same period. Therefore, the US currency trades 15% above its Purchasing Power Parity equilibrium, the most among the major currencies (Chart I-13).4  The US balance of payments picture is becoming increasingly problematic for the dollar. After a surge this spring, US private-sector savings are set to decline. Low interest rates and asset bubbles will increasingly incentivize consumption, while rising capex intentions point to a drop in the corporate sector’s savings. Given that we anticipate the fiscal balance to remain negative in the coming years, the national savings rate will sag, which will worsen the US current account (Chart I-14).5 In other words, the US twin deficits will balloon as the recovery progresses. Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. The US capital account will not offset the impact on the dollar of a wider current account deficit. US real interest rate differentials have collapsed and foreigners have shunned the Treasury market (Chart I-15, top panel). The Fed conducts the loosest monetary policy among the major economies, which is pushing the US shadow rate lower versus the euro area. Such a trend is euro bullish (dollar bearish) because it draws capital outside of the US economy (Chart I-15, middle panel). Additionally, the USD’s counter cyclicality will be its final undoing during the global economic recovery and will create another hurdle for the US capital account. Chart I-14A Dollar-Bearish Savings Backdrop Chart I-15No Love For The Greenback Chart I-16The Dollar Is Ripe For A Rebound Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. Our dollar capitulation index is overextended and if stocks experience heightened volatility (see equities on page 32), then a safe-haven asset such as the greenback will catch a temporary bid (Chart I-16). A correction in the euro to 1.15-1.14 is a reasonable target. Government Bonds Our reluctance to overweight bonds or duration is intact. The BCA US 10-Year Government Bond Valuation index is consistent with higher yields in the next 12 months (Chart I-17). Moreover, bond prices are losing momentum, which creates a technical vulnerability for this asset class. The economy is the potential catalyst to expose the underlying valuation and technical risks of government bonds. Inflation is still a distant danger, but our BCA Pipeline Inflation indicator highlights that deflationary pressures are receding (Chart I-18, top panel). Likewise, our Nominal Cyclical Spending proxy already warns that yields have upside; and an expanding recovery implies that bond-bearish pressures will progress (Chart I-18, bottom panel). Chart I-17The Traitorous Treasury Market Chart I-18Problems For Treasurys   The Fed’s switch to an average inflation target is also consistent with higher long bond yields. The Fed’s newfound tolerance for loftier inflation should lift long-term inflation expectations and medium-term inflation uncertainty, especially given current fiscal trends. Higher long-term inflation expectations and inflation uncertainty have the potential to generate a broader range of policy-rate outcomes, therefore they will also normalize the extraordinarily depressed term premium and lead to a steeper yield curve (Chart I-19). Thus, 10- and 30-year yields have room to increase even if current short rates remain anchored near their lower bounds for the next three years. Over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. The expected yield upside will be limited in the next year. While investors should anticipate some curve steepening, the most violent selloffs only take hold of the Treasury market when the Fed generates hawkish surprises, which is very unlikely in 2021 (Chart I-20). Moreover, the stock market creates its own constraints. As our European Investment strategist has reasoned, higher yields will hurt growth stocks that derive a disproportionate share of their intrinsic value from long-term cash flows.6 If bond prices fall too quickly, then these growth stocks would plunge and drag down the equity market. In essence, elevated bond yields can generate a deflationary shock that undoes the primary reason why yields would rise. Therefore, over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. Chart I-19Average-Inflation Targeting Hurts Long-Dated Bonds Chart I-20Limited Upside For Yields   Equities Several factors underpin our positive stance on global equities in the next 12 months. The lack of investment alternatives or TINA (There Is No Alternative) is a crucial support under stock prices. As BCA Research’s Global Investment Strategy service recently discussed, the S&P 500’s dividend yield stands at around 100 basis points above 10-year Treasury yields.7 Conservatively assuming that dividends per share remain constant in the next 10 years and inflation averages 2%, the real value of the US equity benchmark must decline by 25% during that period before it underperforms Treasurys. Given that gaps between dividend yields and bond yields are even larger outside the US, many foreign bourses must experience deeper real depreciation before they underperform their respective bond markets (Chart I-21). Corporate pricing power is returning, which is positive for the earnings outlook. The ability of firms to boost prices will be enhanced by the combination of a weak dollar, declining deflationary forces, rebounding commodity prices and a surge in the sales-to-inventory ratio. The pickup in pricing power is broadly based; 59% of the S&P 500 groups analyzed by our US equity strategist are experiencing mounting prices.8 When higher pricing power meets mending sales volumes, operating leverage allows profit margins to expand, which lifts earnings per share and stock prices (Chart I-22). Chart I-21TINA Flatters Stocks Chart I-22Corporate Pricing Power Is Coming Back Chart I-23Liquidity Underpins This Rally The global monetary environment also supports stocks. The swell in our US Financial Liquidity index is consistent with additional equity gains because it forecasts stronger economic activity (Chart I-23). Expectations of an upswing in the business cycle let earnings forecasts climb and can also improve the anticipated growth rate of long-term earnings while encouraging risk-taking, which compresses the equity risk premium. Moreover, generous liquidity limits the upside to real yields, which further boosts equity multiples. Another consequence of ample liquidity is a marked increase in corporate actions. Firms engage in greater M&A activity, which can generate gains in accounting earnings while withdrawing equity from the market. Businesses around the world have tapped the corporate bond market at a record pace this year, creating both large war chests and the capacity to deploy funds for capex. Higher capex boosts demand and cyclical spending, which creates a positive environment for earnings. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. The US and G-10 economic surprise indices are elevated, but they are losing momentum. This deterioration in the second derivative of activity is problematic when there is a non-trivial chance of a policy error in Washington. Importantly, the upcoming US election will raise questions about the regulatory environment for the two market heavyweights: technology and healthcare stocks. As we wrote last month, a shift of leadership away from these sectors will translate into episodic corrections for stocks at large.9 Additionally, investors must price in the risk of gridlock in Washington. If Senate Republicans are reluctant to write a check while an unpopular President Trump faces an imminent election, then their willingness to expand spending if Biden clinches the White House will be nonexistent. A complete refusal to add fiscal stimulus would nearly guarantee a double-dip recession. Equities must embed a risk premium against this scenario ahead of the election. Therefore, the S&P 500 is likely to test 3000 in the coming weeks before rebounding. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. Sector Considerations We are positive on the medium-term outlook for value versus growth stocks. The cheapness of value versus growth makes the former attractive, but is not enough to allocate funds to it aggressively. Instead, our bias takes root in our economic view. The forward earnings of global value stocks are very depressed relative to growth stocks. However, the ratio of value EPS to growth EPS is extremely pro-cyclical. Thus, our positive stance on global growth is consistent with a rebound in relative profits that will help value equities (Chart I-24, top panel). Moreover, higher yields correlate with a re-rating of relative equity multiples in favor of value stocks, which are less sensitive to rising discount rates than their growth counterparts (Chart I-24, bottom panel). In this context, we continue to favor industrials and materials; consumer discretionary stocks are also appealing.10 Investors should underweight the US, especially in common currency terms. Gold mining equities remain attractive long-term investments. In the near term, as long as the dollar counter-trend bounce continues, gold will purge its excess froth (Chart I-25, top panel). Nonetheless, our trend indicator remains positive for gold (Chart I-25, bottom panel). Moreover, if real yields start to stagnate at their current low levels, then gold will lose a tailwind but it will not develop a new handicap. In this context, an increase in inflation expectations will elevate gold prices (Table I-1). Other bullish cyclical forces underpinning gold include the dollar’s long-term bear market, limited supply expansion and the diversification of EM central banks away from Treasurys into gold. This positive backdrop should allow the attractive relative valuation of global gold mining firms and their improving operating metric (courtesy of rigorous cash flow management and limited expansion plans) to blossom into more equity price outperformance over the next year or so. Chart I-24Long Growth vs Value: A Cyclical Trade Chart I-25A Shakeout For The Gold Bull Market Table I-1Gold's Response To Yields Finally, Japan has become our favorite equity market for the next 9 to 12 months. Japanese stocks possess the perfect equity exposure to play the themes we espouse because they greatly overweight industrials and traditional consumer discretionary stocks at the expense of tech and healthcare (Table I-2). Moreover, we like auto stocks, an industry well represented in the Japanese bourse, which will benefit from a weak trade-weighted yen.11 Lastly, Japanese stock prices incorporate a large margin of safety. Most sectors in Japan trade at a significant discount to their European and US counterparts (Chart I-26). Nevertheless, it is too early to make a structural bet on Japan because its productivity problems and persistent deflation generate a long-lasting drag on corporate profitability. Table I-2Japan Possesses An Attractive Sector Composition Chart I-26Japan Is A Cheap Recovery Bet Section II presents a thought experiment by our Chief US Equity Strategist, Anastasios Avgeriou, which details the feasibility of a doubling of the S&P 500 over the coming 8 years. I trust you will find this report based on historical evidences thought-provoking.   Mathieu Savary Vice President The Bank Credit Analyst September 24, 2020 Next Report: October 29, 2020   II. SPX 7000 We present a thought experiment for the next eight years. 7000 constitutes a reasonable long-term target for the S&P 500. A doubling of the S&P 500 over the coming eight years is in line with the historical experience. Monetary policy is unlikely to tighten meaningfully, which will allow multiples to remain elevated Earnings per share can rise to $310 by 2028. Market technicals are also consistent with significant long-term gains for stocks. Chart II-1Prolonged ZIRP Neither Eliminates Corrections... Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart II-1). Seven years. As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart II-1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart II-2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart II-3). Chart II-2...Nor Mini Economic Cycles Chart II-3"Lowflation"/Disinflation Has Been The Story Of The Past 30 Years   Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart II-2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart II-3). Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. Table II-1 With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table II-1). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart II-4). Chart II-4Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart II-5). Chart II-5EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table II-2 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table II-2SPX EPS & Multiple Sensitivity With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart II-5). A few words on presidential cycles are relevant given our structural bullish equity market view. We first noticed Tables II-3 & II-4 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies12 dating back to Hoover. Table II-3Every Presidency Experiences Drawdowns Table II-4S&P 500 Returns During Presidential Terms What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart II-6). Chart II-6Of Megaphones And Diamonds Chart II-7Diamond Base Is Long Term Bullish While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart II-7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Anastasios Avgeriou US Equity Strategist III. Indicators And Reference Charts The stock market correction has begun in earnest. The S&P 500 is suffering as the economic surprise index deteriorates, the dollar rebounds and uncertainty surrounding fiscal policy takes center stage. The deteriorating performances of silver, investment grade bonds, small-cap stocks, EM currencies and the AUD/CHF cross confirm that the equity market will suffer more downside. Moreover, the number of NYSE stocks trading above their 10-week moving average is in free-fall but remain well above levels consistent with a bottom. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. The shift to an average-inflation target by the Fed, which the ECB is also considering, buttresses this dovish stance further as inflation will have to rise even more than normally before the major global central banks tighten policy. Moreover, outside of the US, fiscal policy remains accommodative. Even in the US, we expect more stimulus to come through before the November election. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator has softened but it remains at the top of its pre-COVID-19 distribution, which balances the expensiveness of the market flashed by our Valuation Indicator. Putting those forces together, our Intermediate-Term Indicator and our Revealed Preference Indicator strongly argues in favor or staying invested in equities. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor around 3000. At this level, the froth highlighted by our Speculation Indicator will have dissipated. Despite the equity correction, bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. Moreover, our Cyclical Bond Indicator has turned higher and is now flashing an outright sell signal. In effect, with rates near their lower bound, the market understands that yields have little room to decline and thus bonds seems to be losing their ability to hedge equity risk. Thus, bonds yields are unlikely to rise as stocks correct, but their lack of downside right now suggests that when equities regain their footing, 10-year Treasury yields could quickly move higher toward 1%. The dollar countertrend rally that we expected last month has begun. So far, the dollar has still not purged its oversold conditions and the deterioration in risk sentiment around the world will likely result in additional upside for the greenback. Ultimately, this rally will be temporary. The global economic recovery has just begun, the US balance of payments picture is deteriorating and the USD trades at a large premium to its purchasing power parity equilibrium. Commodities remain in a bull market, but their current correction has further to run. As investors absorb the deterioration in economic surprises and risk sentiment declines, the overbought commodity complex will remain under downward pressure. The strength in the US dollar is creating an additional powerful headwind against commodities. Gold’s decline has been particularly noteworthy. Gold remains above its short-term fair value, hence its vulnerability to the dollar and to the decline in our Monetary Indicator is particularly pronounced. A stabilization in gold and silver prices is required before the rest of the commodity complex and stocks can find a firmer footing. Stronger precious metals would indicate that the deterioration in liquidity visible at the margin is ending. It is likely to be contemporary with the passage of a new fiscal stimulus bill in the US. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see  Emerging Markets Strategy "Charts That Matter," dated September 10, 2020, available at ems.bcaresearch.com 2 The Atlanta Fed GDPNow model already points to an annualized growth rate of 32% in Q3 in the US, but the New York Fed’s model pencils in a much more modest 5.3% expansion rate for Q4. 3 Please see  US Bond Strategy "More Stimulus Needed," dated September 15, 2020, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy "Revisiting Our High-Conviction Trades," dated September 11, 2020, available at fes.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020 and The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 6 Please see European Investment Strategy "The Puppet Master Is The 30-Year Bond," dated August 6, 2020, available at eis.bcaresearch.com 7 Please see Global Investment Strategy "Stock Prices And Interest Rates: Can We Trust TINA?," dated September 11, 2020, available at gis.bcaresearch.com 8 Please see US Equity Strategy "Pricing Power Update," dated September 14, 2020, available at uses.bcaresearch.com 9 Please see The Bank Credit Analyst "September 2020," dated August 27, 2020, available at bca.bcaresearch.com 10 However, in the US, investors must be careful as the sector is dominated by one firm: Amazon, which trades as a tech stock, not as a traditional consumer discretionary. 11 Please see Daily Insights "More Cars Please!" dated July 20, 2020, available at di.bcaresearch.com 12 By term presidencies we are referring to the different duration of Presidents staying in office.

Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics.   Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long.   Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent.   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights Lower-income Chinese households are overly indebted, while higher-income groups hold too much cash.  Apart from real estate and cash, ordinary Chinese people have few choices in allocating their assets. Household consumption has not been stimulated to the same degree as during previous cycles. The recently announced “dual circulation” strategy may not be an imminent solution to China’s chronic high debt, high savings issue. However, an acceleration in policy actions of late may be steps in the right direction in encouraging Chinese households to spend more domestically and to invest in domestic companies. Feature The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably, the pace of consumer spending growth started decelerating almost two years before the pandemic struck the country (Chart 1). Chart 1Chinese Consumers Scaled Back Spending Before COVID-19 Chart 2Chinese Households Save Cash, Lots Of It Furthermore, Chinese households have added a total of 8.3 trillion yuan to their bank deposits so far this year, or about 8% of China’s 2019 national output (Chart 2). Outsized cash savings helped to cushion consumers from the pandemic’s economic impact and will support a consumption rebound as China’s economic and service sector activities continue to normalize. However, an acceleration in cash savings and decline in households' propensity to spend would not bode well for a structurally balanced economic growth model. Chinese policymakers recently announced a new “dual circulation” strategy, and fast-tracked several policy actions to facilitate easier access for households to consume luxury goods and participate in the domestic capital markets. The policies will likely have a small, near-term economic impact. But in the long run they can set up a trend which will benefit domestic consumption growth and better utilize the substantial cash holdings among Chinese domiciles. Too Much Saving Or Too Much Debt? While Chinese households have excessive cash savings, they also carry too much debt. Families hold a total of 55 trillion yuan of debt, or 94% of their aggregate disposable income. The debt-to-income ratio is fast approaching that in the US (Chart 3). At the same time, their debt-to-cash ratio, on an aggregate basis, is extremely low relative to other countries (Chart 4). Chart 3Chinese Households Are Almost As Leveraged As The US Ones Chart 4But They Also Hold Way More Cash Than The US Ones Chinese people are net savers, and only about 30% of Chinese families are in debt, which is less than half of the number in the US (Chart 5 and Table 1). This means approximately two-thirds of households have a positive net worth. On the other hand, Chinese consumers who borrow are deeply indebted. China’s median debt-to-income ratio is around 180%, according to recent surveys, with the lowest income group carrying debt loads that are a whopping 12 times their income (Table 2). Chart 5Two Thirds Of Chinese Households May Be Debt Free Table 1Chinese Household Credit Participation Rate Table 2Chinese Household Debt-To-Income Ratio, By Income Groups Bottom Line: Lower-income groups are heavily indebted, while higher-income families have too much cash on hand.  Too Few Investment Choices Chinese households hold a majority of their assets in real estate investments and cash. The former has seen prices skyrocket, crowding out the discretionary spending capability of lower-income families.1 On the other hand, cash and cash equivalents such as CDs, currently earn a meager 2%. The obsession with holding properties has been reinforced by the astonishing pace of money creation in the past 10 years (Chart 6). Despite sky-high prices, real estate has been the main counter-inflation measure in China. According to the 2019 China Household Finance Survey, nearly 60% of Chinese household debt is in home loans, which is about twice the number compared with the US. Furthermore, the share of second-home loans (as a share of all residential housing loans) escalated from less than 30% in 2011 to 65.9% in 2018, greatly exceeding the share of first home loans. Post-pandemic demand for housing has remained strong and household debt is still expanding faster than nominal disposable income growth (Chart 7). Even though lower-income groups have significantly scaled back on mortgages, given that such a large portion of household assets is tied up in real estate means that any deflation in property prices will have a devastating impact on consumer net worth (Table 2 on Page 4). Consequently, discretionary spending by even middle- and high-income households will be curtailed. Chart 6Helicopter Money In China Chart 7Household Credit Still Expands Faster Than Income Growth In addition to the long-standing issue of a lack of social safety net, Chinese families’ high cash holdings are due to a lack of investment alternatives. Even though the country has the world’s second largest equity market by value, only 11% of Chinese residents participate in the stock market, a dismal number compared with a 50% equity market participation rate in the US.2 The low participation rate is not surprising: over a 10-year time span, returns on cash have more or less matched returns on A-share stocks (Chart 8). The extreme volatility in Chinese equities has curbed citizens’ enthusiasm to participate in the market. Chart 8Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Bottom Line: Chinese household profile is characterized by the heavy concentration of cash among higher-income households and the elevated indebtedness of low-income ones stemming from sky-high real estate prices. Is The New “Dual Circulation” Strategy A Solution? Consumer spending in China has been growing rapidly in the past 20 years, at a rate roughly in line with the increase in disposable incomes. Income and consumption growth peaked in 2007 but since then has been dwindling along with falling productivity (Chart 9). Cyclically, the consumption recovery will bring its growth rate back to the pre-COVID 19 level. Demand for real assets and consumer durable goods has been strong after the pandemic (Chart 10). Even the demand for luxury goods has made a comeback.3   Chart 9Chinese Consumption, Income, And Productivity Growth Chart 10Chinese Consumption Is Recovering However, for consumption to sustain an expansion rate similar to the past decade, China’s productivity growth must accelerate and, in turn, boost per capita income growth. Conversely, the country would need to maintain a high rate of credit expansion to generate enough economic growth and inflation to spur strong nominal income growth (Chart 11). Credit expansion can boost nominal growth but it is productivity growth that generates per capita income growth.  Chart 11Household Credit Impulse Has Been Muted Since 2018 The recently announced “dual circulation” strategy and an acceleration in policy actions by the Chinese leadership may suggest a different path than in previous cycles. Policymakers seem to focus on changing and upgrading the composition of China’s existing consumption base rather than boosting consumption growth through monetary stimulus in the household sector. Moreover, they are looking to change the configuration of family savings and investments. Our colleagues at BCA Research's Emerging Markets Strategy have stated that improvements in the turnover of consumers’ bank deposits and cash, if successful, may allow China to slow its overall credit and money growth but still sustain a steady nominal GDP growth rate.4 Details of the new “dual circulation” strategy are sparse, but we think the following developments in the past couple of months are relevant to investors: Bringing home overseas consumption and reducing the service trade deficit: China fast-tracked policies that target duty-free shopping venues, a strategy designed to lure Chinese consumers back to the domestic market. Beijing made unprecedented moves to invigorate Hainan province’s duty-free shopping and issue new licenses to allow companies to operate duty-free shops both online and offline. In the past five years, Chinese residents have spent an average of 250 billion USD annually shopping overseas. Purchases of duty-free products overseas account for a small share of China’s 12.5 trillion yuan retail industry. Nonetheless, repatriating some overseas consumption would allow China to not only narrow its service trade deficit, but also to create more service businesses and jobs internally (Chart 12).  The move signifies that Chinese policymakers are committed to change domestic consumer spending behavior while upgrading the retail industry. However, we remain cautious on retail stocks in the next 6 to 12 months. Retail growth has not yet rebounded to its pre-pandemic level, and the valuations in retail-sector stocks are overly stretched (Chart 13). Chart 12China Has Been Running A Huge Service Trade Deficit Chart 13Retail Sector Valuations Are Elevated   Increasing households’ equity holdings in domestic companies: Direct financing in the form of equities and corporate bonds only accounts for about 15% of total social financing, compared with 65% in bank lending. Chinese corporations rely mostly on bank loans and retained earnings, whereas US companies are heavily dependent on equity financing. The “dual circulation” strategy encourages more direct financing for SMEs, science and technology companies. It also explicitly calls for a greater household participation in the financial markets, which would guide more savings into domestic capital markets. In the past few months, the government has accelerated financial market reforms aimed at providing easier access for corporations and individuals to domestic equity markets. In the first half of this year, 119 companies went public in Shanghai and Shenzhen; these companies raised about 140 billion yuan, which was more than double the amount from a year ago. New individual investor accounts on the Shanghai exchange rose by 30% (year to date) from a year ago. Notably, both the IPO and household participation rates resemble the onset of the boom-bust cycle in 2015. However, this time Chinese regulators have been much more vigilant and restrictive about over-leveraging, acting early and removing some steam from retail investor rush (Chart 14). Chart 14Chinese Authorities Have Less Tolerance For Equity Market Leverage Chart 15Chinese Stocks Still Have Upside Potentials It remains to be seen whether the authorities will be able to boost and sustain consumer confidence in the domestic equity market. The efforts by the Chinese government will either succeed by securing a gradual and healthy secular bull market, or they will fail by triggering another boom-bust cycle in the domestic market. Either way, investors should stay overweight Chinese stocks on at least a 6-month horizon (Chart 15).   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Households in the bottom 40 percentile in China have no discretionary spending capacity. “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 2投保基金公司《2019年度全国股票市场投资者状况调查报告》and Pew Research Center. 3China ‘Revenge Spending’ Offsets Plunge in Luxury Goods Revenue 4Please see Emerging Markets Strategy Special Report "China’s Rebalancing: Will Consumers Rise To The Challenge?" dated August 29, 2019, available at ems.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights China’s surge in refined copper imports allows it to cover a structural short position it has in this critical commodity – mostly in its unrefined state – and ensures the stimulus being deployed to revive its economy ahead of the 100th anniversary of the founding of the Communist Party in July will not falter due to a lack of basic raw materials (Chart of the Week). We expect continued resilience in commodities generally into 2021 – particularly in base metals, iron ore and crude oil – as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its robust economic growth. As with oil, we expect copper demand will benefit from a weaker USD and stronger global trade. The odds of a COVID-19 vaccine being available by year-end or early 2021 remain favorable, which also will support a revival in demand.1 We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 to finish at $3.15/lb. We would not be surprised by higher prices, and are, therefore, getting long December 2021 COMEX copper at tonight's close. Feature The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. COVID-19 may have derailed the Communist Party’s realization of the “Chinese Dream” this year, wherein the leadership vowed real per-capita GDP would double in the decade ending in 2020, but it is unlikely to diminish the celebration of the Party’s 100th anniversary in July.2 Chart of the WeekVol Falls As Know Unknowns Are Resolved The global commodity-demand destruction caused by the COVID-19 pandemic depressed the prices of commodities generally, particularly those which China is structurally short – e.g., copper, iron ore, oil and natural gas. As terrible as the pandemic has been in human terms, it has allowed Chinese firms and the State Reserve Bureau to sharply increase imports of refined copper, which rose 34% in the January-to-July period to 2.5mm MT amid such low prices, which bottomed at $2.10/lb in late March and now are trading above $3.00/lb.3 China accounts for more than 50% of global refined copper consumption and ~ 40% of refined production (Chart 2).4 Chart 2China Dominates Metals Consumption The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. Global copper ore and concentrate supply fell ~ 3% y/y in 2Q20, led by a 28% decline in Peru’s mine production, according to the World Bureau of Metal Statistics (Chart 3). This was a result of containment policies that limited mining activities to slow the pandemic’s spread in Latin America. In Chile, COVID-19 cases stabilized in recent months at around 100 per million people (Chart 4). In Peru, cases have been declining since August, but from an elevated level. Supply is expected to recover rapidly as these economies reopen, but further mine disruptions remain a risk. Chart 3Peru's Copper Ore Supplies Recovering Chart 4COVID-19 Copper Supply Risks Falling Commodity-Demand Indicators Move Higher we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. Global central banks and government stimulus unleashed in the wake of the COVID-19 pandemic, combined with a depreciating US dollar, pushed our commodity-demand indicators higher over the last few months (Chart 5). This supported copper prices, which are up 42% since their March 23 low. Moreover, the pickup in economic activity in China’s major trading partners provided further support to copper demand, given that ~ 17% of China’s copper consumption comes from exports of products containing copper (Chart 6).5 Chart 5Commodity Demand Is Reviving Chart 6Expect Chinese Employment Gains As Economy Continues To Recover For the balance of 2H20, we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. These are key factors driving our positive view on metal – especially copper – prices. Communist Party’s 100th Anniversary Will Boost Commodity Prices China’s buying spree for commodities it is structurally short – particularly copper, iron ore and oil – minimizes the risk fiscal and monetary stimulus deployed to revive its economy will be derailed this year or next. This is particularly important next year: We expect stimulus will continue and will be hitting the economy full force in time for the Communist Party’s centennial celebrations in July. For the infrastructure and construction spending that will be spurred by the massive stimulus, this is critical to spurring employment – a key goal of the Party’s domestic harmony focus – domestic manufacturing, services, and exports (Chart 6).6 This will keep demand for copper – and commodities generally – strong into 2021, as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its world-beating economic performance. And, because stocks of critical commodities are increasing as stimulus is hitting the domestic economy next year, the risk of massively inflating prices while the county is celebrating the Party’s centennial in July – as happened following the Global Financial Crisis (GFC) – is minimized, but not completely eliminated (Chart 7). Chart 7COMEX Stocks Will Move To China That said, we still expect copper to move higher next year. In our modeling of prices, we note world PMIs, EM FX rates, the USD, also drive copper prices, in addition to those factors discussed above specific to China. We expect COMEX high-grade copper prices to end 2020 at $3.00/lb, and to average $3.11/lb next year (Chart 8). On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close, expecting 2021 to end at $3.15/lb. Chart 8Copper Prices Expected To Increase Risks To Our Copper View Geopolitical risks remain the chief threat to our bullish copper view. The US Presidential election campaign rhetoric, in particular, has turned bellicose vis-à-vis China, with President Donald Trump threatening to “decouple” economically from China if he is reelected.7 These sorts of pronouncement threaten to escalate what could now be considered a trade dispute to an all-out trade war, particularly if it includes sanctions against US firms investing in manufacturing and services in China, as Trump promises. At the limit, this would put a long-term bid under the USD, and reverse the nascent recovery in commodity demand resulting from a weaker dollar. Outright military confrontation between the US and China also is a risk, particularly as tensions in the South China Sea and the Asia-Pacific region continue. The most likely confrontation would be an escalation of hostilities resulting from a naval or aerial face-off, the number of which has been steadily increasing. The threat of a second wave of COVID-19 also remains a risk, particularly if it results in another round of lockdowns globally. That said, we believe the odds of this are very low, as the capacity to absorb another shutdown in economic activity in DM and EM economies likely has been exhausted by measures already implemented this year. It is highly unlikely any economy can afford another round of economic shutdown without triggering an economic depression. Bottom Line: China’s surge in refined copper imports allows it to cover its structural short position in the commodity, and, equally importantly, to ensure an expected revival of economic activity into 2021 – when the Communist Party celebrates its 100th anniversary – will not falter because it lacks basic raw materials. We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 prices to average $3.11/lb. On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices dipped below $40/bbl for the first time since mid-June. Prior to this move, prices had been stable in a narrow range around $43/bbl since mid-June. Pessimism is increasing re the outlook for demand, as Saudi Arabia reduced its official selling prices (OSPs) for crude delivered to Asian buyers by $1.40/bbl. The negative sentiment was exacerbated by the selloff in tech stocks that began last Thursday. WTI net speculative positions are down to 20% of total open interests vs. 22% in July, as hedge funds exit oil markets. Base Metals: Neutral The LMEX index is up 4% over the past four weeks, supported by higher metals’ consumption and imports in China. Moreover, mobility trends in Europe, Japan, and the US have begun to turn up again in recent weeks based on Apple mobility data. The recovery in China’s economic activity remains the main pillar of our base metals outlook. However, Europe, Japan, and the US still represent a non-negligible share of global metal demand (e.g. ~ 24% copper consumption). Hence, the recent uptick in mobility data is constructive for base metal prices.  Precious Metals: Neutral Gold prices are down 2% since last week, pressured by a slight increase in the US dollar and real rates. The divergence in COVID-19 cases between the US and Europe increases the risk of a short-term bounce higher if this leads to the US economy outperforming that of the EU (Chart 9). Still, mounting geopolitical risks ahead of the US election, lower-for-longer interest rates, and a resumption of the downward trend in the USD over the medium term should support gold later this year. Ags/Softs:  Underweight Soybean prices remain steady, near 2-year highs. The USDA crop progress report listed 55% of soybeans in good or excellent condition for the week ending September 6, 2020. This is a substantial deterioration compared to 66% in those categories last week and 73% at the beginning of August. Corn futures were supported by similar weak supply fundamentals. The USDA reported 55% of corn crops in good or excellent condition against 62% the previous week. Going forward, it will be important to monitor the DXY as it has been strengthening since the beginning of September and could be a headwind to these commodity prices if it breaks to the upside (Chart 10). Chart 9EU Cases Are Rising Chart 10US DXY Strengthening     Footnotes   1     Please see Lower Vol As OPEC 2.0 Gains Control, published September 3, 2020, for additional discussion of vaccine availability. 2     Please see Iron Ore, Steel Poised For Rally, which we published February 13, 2020, for a discussion of the commodity-market implications of China’s dual policy goals of doubling GDP between 2010 and 2020 and preparing for the celebration of the 100th anniversary of the founding of the Chinese Communist Party in 1921. It is available at ces.bcaresearch.com. 3    Please see China's July refined copper imports surge 90% on year boosted by open arbitrage published by S&P Global Platts September 1, 2020. 4    China also accounts for close to 50% of copper ore imports, according to he Observatory of Economic Complexity (OEC). 5    Please see The Impact of the COVID-19 Pandemic on World Copper Supply, published by the International Copper Study Group on May 21, 2020. 6    For an update of the stimulus measures and China’s economic performance, please see China Macro And Market Review published September 9, 2020, by our China Investment Strategy colleagues. It is available at cis.bcaresearch.com. 7     Please see Trump threatens to ‘decouple’ U.S. economy from China, accuses Biden of ‘treachery’ published by marketwatch.com September 7, 2020.       Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades