Commodities & Energy Sector

...And S&P Energy Performance ...And S&P Energy Performance One of the sectors that benefits from a falling greenback is the S&P energy sector. The energy sector enjoys a tight inverse correlation with the US dollar (top panel) as the sector has 8 percentage points higher foreign sales exposure than the S&P 500. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (third panel). Finally, the S&P energy companies enjoy a boost to their income statements (bottom panel). In fact, the S&P energy sector was the best performing sector during three US dollar bear markets we analyzed in the most recent Special Report.  

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The Rally Is Underpinned The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions Exploding Liquidity Conditions Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII July 2020 July 2020 The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left July 2020 July 2020 Chart I-6The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There July 2020 July 2020 Chart I-7Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes European Hopes European Hopes Chart I-9Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound July 2020 July 2020 … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave A Different Wave A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break A Needed Digestive Break A Needed Digestive Break Chart I-15Bonds Are Pricey... Bonds Are Pricey... Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message Sweden's Message Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Bearish Dollar Backdrop Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Banks Are Cheap Banks Are Cheap Chart I-22Banks As A Contrarian Bet Banks As A Contrarian Bet Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks Favor Foreign Stocks Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Attractive EM Valuations Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Japanese Stocks As A Trade Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle The End Of The Debt Super Cycle The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Little Room To Cut Taxes Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth July 2020 July 2020 Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds July 2020 July 2020 The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best ...But Gold Looks The Best ...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism July 2020 July 2020 Chart II-3USA: From Nationalism To Anti-Nationalism July 2020 July 2020   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession July 2020 July 2020 Chart II-5World Conflicts Rise After Major Crises July 2020 July 2020   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism July 2020 July 2020 Chart II-9US And EU Crack Down On Immigration July 2020 July 2020   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count July 2020 July 2020 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020 Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War July 2020 July 2020 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance July 2020 July 2020 Chart III-8Global Stock Market And Earnings: Relative Performance July 2020 July 2020   FIXED INCOME:   Chart III-9US Treasurys And Valuations July 2020 July 2020 Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

The Fed’s efforts to jawbone the US dollar are paying off as investors have been shedding their greenback exposure over the past several weeks. In recent research,1 we have also been highlighting that although Powell would never admit it, the Fed is trying to devalue the greenback and reflate the global economy. The knock-on effect of a depreciating USD is to rekindle S&P sales. According to S&P Dow Jones Indices,2 the SPX derives approximately 43% of its sales from abroad making the US dollar among the key macro profitability drivers (Chart 1, middle panel, US dollar shown advanced and inverted). One of the mechanisms to undermine the greenback is to flood the market with dollars. Ample US dollar based liquidity has historically served as a catalyst to reignite global growth and consequently S&P earnings (Chart 1, bottom panel). Chart 1US Dollar - The Key Driver US Dollar - The Key Driver US Dollar - The Key Driver Chart 2Bearish Across All Timeframes Bearish Across All Timeframes Bearish Across All Timeframes The Dollar: A Bearish Case The fate of the US dollar is yet to be sealed, but piling evidence suggests that the path of least resistance will be lower. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (Chart 2, top panel, dotted red line), but now the US Congressional Budget Office (CBO) estimates3 that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (Chart 2, middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 induced recession and resulting money printing will likely exert extreme downward pressure on the US dollar (Chart 2, bottom panel). Summarizing, when looking across three different time horizons, the evidence is pointing toward a weakening US dollar for the foreseeable future. SPX Sectors And US Dollar Correlations With a rising probability of a US dollar bear market on the horizon, it pays to look back in time and examine which S&P GICS1 sectors benefited from a depreciating US dollar. The purpose of this Special Report is to shed light on the empirical evidence of SPX sectors and USD correlations and serve as a roadmap of sector winners and losers during USD bear markets. Table 1 provides foreign sales exposure for each of the sectors. All else equal, a falling greenback should be synonymous with technology, materials, and energy sectors outperforming as they are the most internationally exposed sectors. In contrast, should the USD change its course and head north, financials, telecom, REITs, and utilities will be the key beneficiaries. Why? Because most of these industries are landlocked in the US and thus in a relative sense should benefit when the US dollar roars. Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell To confirm the above hypothesis, we have identified three previous US dollar bear markets (Chart 3) and computed GICS1-level sector relative returns (Table 2). Chart 3US Dollar Bear Markets US Dollar Bear Markets US Dollar Bear Markets Table 2S&P 500 Gics1 Returns* During US Dollar Bear Markets US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell Looking at median return profile reveals that our hypothesis held as all three: technology, materials, and energy decisively outperformed the market when the US dollar headed south. Similarly, domestically focused and predominately defensive industries such as utilities and telecoms underperformed the market with the consumer staples sector being a notable outlier – something that we address in the consumer staples section of the report. What follows next is a detailed discussion on each of the GICS1 sectors historical relationship with the US dollar, ranked in order of foreign sales exposure from highest to lowest. For completion purposes, we also provided S&P 500 GICS1 relative sector performance against the US dollar charts since 1970 in the Appendix.     Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Technology (Neutral)  Technology sits atop the foreign sales exposure table garnering 58% of revenues from abroad, which is a full 15% percentage points higher than S&P 500 (Table 1). In two out of the three periods of USD bear markets that we examined, tech stocks bested the broad market and the median outperformance sat over 9%. Nevertheless, the correlation between the US dollar and relative share prices is muted over a longer-term horizon (see Appendix Chart A1 below). Likely, one reason for the inconclusive long-term correlation between tech and the greenback is that the majority of tech gadgets are manufactured overseas (Chart 4, third panel). Therefore, an appreciating currency boosts margins via deflating input costs. Tack on the resilient nature of demand for tech hardware goods and especially software and services which preserves high selling prices and offsets and negative P&L losses from a rising greenback. We are currently neutral the S&P technology sector and employ a barbell portfolio approach preferring software and services and avoiding hardware and equipment. Chart 4Technology Technology Technology Materials (Neutral) The materials sector behaves similarly to its brother the energy sector as both move in the opposite direction of the greenback (Chart 5, top panel). Consequently, materials stocks have outperformed the market during periods of US dollar weakness that we analyzed. The third panel of Chart 5 shows that our materials exports proxy is the flip image of the greenback. This tight inverse relationship is exacerbated by the negative impact of a firming dollar on underlying metals commodity prices (Chart 5, second panel). As a result, materials profit margins widen when the dollar falls and narrow when it rises. Ultimately, S&P materials earnings reflect this USD-commodity dynamic (Chart 5, bottom panel) We are currently neutral the S&P materials index. Chart 5Materials Materials Materials Energy (Overweight) The energy sector enjoys a tight inverse correlation with the US dollar (Chart 6, top panel) as it is the third most globally exposed sector as shown in Table 1 with 51% of sales coming from abroad. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (Chart 6, second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (Chart 6, third panel). Finally, the S&P energy companies enjoy a boost to their income statements (Chart 6, bottom panel), which explains the sizable median sector outperformance of 43% during dollar bear markets as highlighted in Table 2. We are currently overweight the S&P energy sector and have recently capitalized on 40%+ combined gains in the long XOP/short GDX pair trades.4 Chart 6Energy Energy Energy Industrials (Overweight) US industrials stocks’ foreign sales exposure is on a par with the S&P 500, which explains why the sector only barely outperformed the broad market during periods of dollar weakness. Still, the correlation between this manufacturing-heavy sector and the greenback is negative (Chart 7, top & second panels). Similar to its deep cyclical brethren (materials and energy), the link comes via the commodity channel. A softening dollar boosts global growth, which in turn supports higher commodity prices. Not only do US capital goods producers benefit from overall rising demand (i.e. infrastructure spending), but also via market share gains in global markets as the falling greenback results in a comparative input cost advantage (Chart 7, third panel). Finally, P&L translation gain effects act as another fillip to industrials stocks profits when dollar heads south. We are currently overweight the S&P industrials index. Chart 7Industrials Industrials Industrials Health Care (Overweight) The defensive health care sector is positively correlated with the dollar as its foreign sales revenues are below the ones of the SPX (Chart 8, top panel). Moreover, empirical evidence suggests that the relationship between the sector’s exports and the USD has been mostly positive, which is counterintuitive (Chart 8, middle panel). Keep in mind that pharma and biotech represent roughly half the index and derive 75%+ of their profits domestically as they dictate pricing terms to the US government (it is written into law). This is not the case in Europe where the NHS and the German government for example, have a big say on what pharmaceuticals can charge for their drugs. The bottom panel of Chart 8 summarizes the domestic nature of the health care sector, highlighting the tight positive relationship between the sector’s earnings and the greenback. We are currently modestly overweight the S&P health care sector. Chart 8Health Care Health Care Health Care Consumer Discretionary (Overweight) While the impact of the US dollar on the consumer discretionary sector varied over time switching from a positive to a negative and vice versa, today the sector enjoys a positive correlation with the currency (Chart 9, top panel). The 33% foreign sales exposure may appear as a significant proportion, but it is still a full 10% percentage points below the SPX (Table 1). The implication is that even though the exports benefit from a falling dollar (Chart 9, middle panel), this bump is not enough to drive sector outperformance. Likely, the key reason why consumer discretionary stocks currently enjoy a positive correlation with the dollar is the US large trade deficit. In other words, the US imports the lion’s share of its consumer goods. As the dollar grinds higher, the cost of imports decreases for the US consumer, which provides a boost to companies’ earnings (Chart 9, bottom panel). Tack on the heavy weight AMZN has in the sector (comprising 40% of consumer discretionary sector market cap) and the positive correlation with the currency is explained away. We are currently overweight the S&P consumer discretionary index. Chart 9Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer Staples (Neutral) While a softening US dollar generally favors cyclical industries as it reignites global trade, the defensive S&P consumer staples sector outperformed the overall market on a median basis during USD bear markets (Table 2). Granted, the results are likely skewed as staples stocks rallied more than 300% in the last two decades of the 20th century. Nevertheless, there is a key differentiating factor at play that helped the consumer staples sector trounce other defensive industries during US dollar bear markets. Staples stocks derive 33% (Table 1) of their sales from abroad, whereas other traditional defensive industries (utilities, telecom services) have virtually no export exposure. In other words, given that staples companies are mostly manufacturers, a depreciating currency acts as a tonic to sales via the export relief valve (Chart 10, bottom panel). We are currently neutral the S&P consumer staples sector. Chart 10Consumer Staples Consumer Staples Consumer Staples Financials (Overweight) Financials sit at the bottom half of our Table 1 in terms of their foreign sales exposure, which underpins the sector’s positive correlation with the greenback (Chart 11, top panel), and explains why the sector underperforms the market during dollar bear markets. One of the transmission channels between this sector’s performance and the currency is via increased credit demand. Currency appreciation suppresses inflation and supports purchasing power, and thus loan demand, in addition to keeping bond yields low (Chart 11, middle panel). The process reverses as the US dollar stars to depreciate. We are currently overweight the S&P financials index. Chart 11Financials Financials Financials Utilities (Underweight) Utilities underperformed in all three dollar bear markets we analyzed. As we highlighted in the energy section of the report, a softening dollar is synonymous with higher crude oil prices, which in turn raise inflation expectations. The ensuing selloff in the 10-year Treasury, compels investors to shed this bond proxy equity sector (Chart 12, middle panel). With virtually no exports, utilities also miss on the positive currency translation effects that other GICS1 sectors enjoy. In fact, utilities underperformed by the widest margin on a median basis across all GICS1 sectors (Table 2). This defensive sector typically attracts safe haven flows when the dollar spikes and investors run for cover. This positive correlation with the dollar is clearly reflected in industry earnings, which rise and fall in lockstep with momentum in the greenback (Chart 12, bottom panel). We are currently underweight the S&P utilities sector. Chart 12Utilities Utilities Utilities Telecommunication Services (Neutral) Telecom services relative performance is positively correlated with the dollar, similarly to its defensive sibling, the utilities sector. In fact, telecom carriers go neck-in-neck with utilities as the former is the second worst performing sector during dollar bear markets (Table 2). A softening dollar has proven to be fatal to the industry’s relative pricing power beyond intra industry competition. In fact, industry selling prices are slated to head south anew if history at least rhymes (Chart 13, middle panel). Importantly, this defensive sector is in a structural downtrend and is trying to stay relevant and avoid becoming a “dumb pipeline” with the eventual proliferation of 5G. Worrisomely, telecoms only manage to claw back some of their severe losses during recessions. But, the latest iteration is an aberration as this safe haven sector has failed to stand up to its defensive stature likely owing to the heavy debt load. We are currently neutral the niche S&P telecom services index that now hides underneath the S&P communication services sector. Chart 13Telecom Services Telecom Services Telecom Services REITs (Underweight) Surprisingly, US REITs enjoy an overall negative correlation with the dollar, especially since 1993, and in fact lead the greenback by about 18 months (Chart 14). Our hypothesis would have been a positive correlation courtesy of the landlocked nature of this sector i.e. no export exposure. Granted, in the three periods of dollar bear markets we examined, REITs slightly outperformed the market by 2.5% on a median basis. While the causal link (if any) is yet to be established and the correlation may be spurious, our sense is that forward interest rate differentials are at work and more than offset the domestic nature of this index. REITs have a high dividend yield and thus outperform when the competing risk free asset the 10-year Treasury yield is falling and vice versa (except during recessions). As a result, REITs outperformance is more often than not synonymous with a depreciating currency as lower Treasury yields would exert downward pressure on the USD ceteris paribus.  We are currently underweight the S&P REITs index. Chart 14REITs REITs REITs   Appendix Chart A1Appendix: Technology Appendix: Technology Appendix: Technology Chart A2Appendix: Materials Appendix: Materials Appendix: Materials Chart A3Appendix: Energy Appendix: Energy Appendix: Energy Chart A4Appendix: Industrials Appendix: Industrials Appendix: Industrials Chart A5Appendix: Health Care Appendix: Health Care Appendix: Health Care Chart A6Appendix: Consumer Discretionary Appendix: Consumer Discretionary Appendix: Consumer Discretionary Chart A7Appendix: Consumer Staples Appendix: Consumer Staples Appendix: Consumer Staples Chart A8Appendix: Financials Appendix: Financials Appendix: Financials Chart A9Appendix: Utilities Appendix: Utilities Appendix: Utilities Chart A10Appendix: Telecommunication Services Appendix: Telecommunication Services Appendix: Telecommunication Services Chart A11 landscapeAppendix: REITs Appendix: REITs Appendix: REITs   Footnotes 1    Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2    https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales 3    https://www.cbo.gov/system/files/2020-05/56351-CBO-interim-projections.pdf 4    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.  

Highlights Falling volatility in oil-trading markets will remain suspect while the massive economic uncertainty plaguing global markets persists. Geopolitical risk also will remain high, as the US and China return to loggerheads and India and China move closer to war. Positive consumer and employment data in the US could presage a sharp recovery in demand generally; however, it is immediately countered with fears of a second COVID-19 wave, which now is the baseline scenario of our global investment strategists. Despite lower EM oil-demand growth this year – spurred by weaker GDP growth – deeper production cuts by OPEC 2.0 will keep oil markets on track to rebalance beginning in 3Q20. Massive fiscal and monetary stimulus will bridge global economic activity to a return to normal next year, provided the second wave of the COVID-19 pandemic does not result in renewed lockdown measures. Our updated supply-demand balances keep our expectation for Brent prices at $40/bbl this year and put next year’s average price at $65/bbl, $3/bbl below last month’s forecast. We continue to expect WTI to trade $2-$4/bbl lower than Brent. Feature As the OPEC 2.0 Joint Ministerial Monitoring Committee convenes today, members will be attempting to sort out the appropriate supply response to a highly uncertain oil-demand evolution over the balance of this year and next. Indeed, global economic policy uncertainty is scaling heights unimagined even in the depths of the Global Financial Crisis (GFC) of 2007-09 or the European sovereign-debt crisis of 2010-12, which followed in the GFC’s wake (Chart of the Week). This uncertainty is driving the policy responses of central banks and governments around the world, as they attempt to bridge COVID-19-induced demand destruction and the return to normality they seek in re-opening their economies. The data informing policy are suspect, as are the responses of firms and households to the stimulus they provide. This reflects the near-complete uncertainty in re current economic conditions. This translates directly to estimates of fundamental supply and demand variables, particularly in oil, which has been hardest-hit among the major commodities (Chart 2). Chart of the WeekEconomic Uncertainty Plagues Oil Markets Economic Uncertainty Plagues Oil Markets Economic Uncertainty Plagues Oil Markets Chart 2Oil Hardest Hit Commodity In 2020 COVID-19 Pandemic Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Demand To Weaken More Than Expected In 2020 OPEC 2.0’s agreement earlier this month to extend its 9.7mm b/d production cuts into July likely were informed by weaker physical demand. Our updated oil-demand model – driven by World Bank estimates of DM and EM GDP growth – indicates global oil consumption will fall by close to 9mm b/d this year, or ~ 1mm b/d more than we estimated last month.1 For next year, we expect a stronger rebound – 8.5mm b/d vs. last month’s estimate of 8mm b/d – off a lower base this year. This change is driven by the Bank’s more pessimistic assessment of EM GDP growth for 2020 than the IMF growth estimates we used in last month’s forecast (Chart 3). DM demand will take a harder hit than EM, given the extent of the lockdowns in major systematically important economies. This will set up a stronger rebound in oil demand next year, which, among many things spawned by the COVID-19 pandemic, is rarely seen. Chart 3EM Oil Demand Growth Estimate Lowered EM Oil Demand Growth Estimate Lowered EM Oil Demand Growth Estimate Lowered OPEC 2.0’s agreement earlier this month to extend its 9.7mm b/d production cuts into July likely were informed by weaker physical demand – appearing as unintended inventory accumulation – reflecting slower GDP growth. Global Oil Supply Expansion Required In our updated balances, we expect OPEC 2.0 supply to contract 3.2mm b/d y/y in 2Q20, and to increase in 2H20 and 2021 to keep prices from overshooting in the event the global demand response to fiscal and monetary stimulus is underestimated. We expect US shales to contract 600k b/d this year to 9.3mm b/d of production, and to gradually rebound in 2021 (Chart 4).2 The contraction in US shales will lead non-OPEC 2.0 supply losses in our estimation (Table 1). Chart 4Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Cuts By OPEC 2.0, US Shales Will Remove 9.4mm b/d Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks The combination of reduced supply and higher demand growth beginning next month will produce a physical deficit in 2H20 and in 2021 (Chart 5). This will be apparent in falling storage levels (Chart 6) and in a further flattening and eventual backwardating of the Brent and WTI forward curves (Chart 7). Chart 5Physical Markets Will Tighten Physical Markets Will Tighten Physical Markets Will Tighten Chart 6... Causing Storage to Drain ... ... Causing Storage to Drain ... ... Causing Storage to Drain ... Chart 7... And Forward Curves To Flatten, Then Backwardate ... And Forward Curves To Flatten, Then Backwardate ... And Forward Curves To Flatten, Then Backwardate Chart 8Massive Stimulus Flooding Global Economy Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Upside Favored, But Uncertainty Dominates We reckon even a second wave of the pandemic – now our Global Investment Strategy’s base case – will not derail a recovery in commodity demand. We continue to maintain a bias toward the upside price risk prevailing over the downside – driven by our expectation the massive fiscal and monetary stimulus unleashed globally will serve as an effective bridge from the COVID-19 pandemic to normal economic activity (Chart 8). This is being picked up in BCA Research's Global Nowcast, which closely tracks current economic conditions in leading manufacturing economies (Chart 9). We reckon even a second wave of the pandemic – now our Global Investment Strategy’s base case – will not derail a recovery in commodity demand.3 But the balance could tip the other way, with downside risk dominating the upside. The unprecedented uncertainty now dominating markets makes falling price volatility in oil markets – as measured by the implied volatility of Brent crude oil options’ implied volatility – highly suspect (Chart 10). We continue to emphasize two-way price risk in commodities remains pronounced despite the decline in the implied volatility of traded crude-oil options.4 Chart 9Global Economic Activity Turning Higher Global Economic Activity Turning Higher Global Economic Activity Turning Higher Chart 10Falling Vol Does Not Mean Lower Uncertainty Falling Vol Does Not Mean Lower Uncertainty Falling Vol Does Not Mean Lower Uncertainty Investment Implications The dynamics laid out above continue to point to a tightening physical oil market this year and next and higher prices. However, that does not come without substantial two-way risk. Indeed, the evolution of supply-demand information alone can trigger sharp adjustments in prices, as data revisions – to be expected, given the uncertainty prevailing at present – upend earlier preliminary estimates. We are leaving our 2020 forecast for Brent at $40/bbl and expect 2021 prices to average $65/bbl, $3/bbl below last month’s forecast. We continue to expect WTI to trade $2-$4/bbl lower than Brent (Chart 11). We also expect forward curves to flatten and return to backwardation in Brent and WTI, as the underlying physical markets tighten and inventories draw. Chart 11Brent To Average /bbl In 2021 Brent To Average $65/bbl In 2021 Brent To Average $65/bbl In 2021     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices are recovering from the dual supply and demand shocks delivered by the COVID-19 pandemic and the short-lived OPEC 2.0 internal market-share war. Brent price are now down 42% ytd vs. -72% two months ago. The contango in the Brent futures curve continues to narrow as voluntary and involuntary production cuts take effect and lockdown measures are relaxed in major economies. Continued production losses and demand recovery will force inventories lower, flattening the oil forward curves and ultimately backwardating them. Base Metals: Neutral As of Tuesday’s close, the LMEX index was up 17% since bottoming in March, 2ppt lower than the level reached last week. Positive data out of China – fueled by stimulative fiscal and monetary policies – indicates demand for industrial metals will grow: Year-on-year industrial production, infrastructure spending, and steel production grew by 4.4%, 10.9%, and 4.2%, respectively, in May (Chart 12). Moreover, y/y floor space started and sold moved up to positive territory. As government support continues to reach the economy, these sectors will encourage base metal consumption, providing further upside to the LME index. Still, fresh outbreaks of COVID-19 cases in Beijing – and associated lockdown measures – illustrate the fragility of the recovery over the short-term. Precious Metals: Neutral Gold prices remain range-bound at ~ $1,700/oz, mimicking movements in US real rates. Going forward, both the Fed and market participants expect US interest rates will remain pinned near zero through the end of 2022 (Chart 13). Our US Investment strategists expect the Fed will err to the side of providing too much accommodation as it navigates the uncertain consequences of the current economic shock. A gradual rebound in inflation next year could push real rates deeper in negative territories, which will be supportive for gold. Ags/Softs:  Underweight July soybean prices are up more than 3% since the beginning of the month. Strong export prospects going forward contributed to the strength in prices this past week. On June 4th the USDA reported new sales of soybeans of 1.21 MM MT, a huge week-on-week jump, which brought outstanding sales for the next marketing season to 4.1 MM MT. China was responsible for close to half of these sales and private exporters have since reported a little over an additional 1 million MT of exports to China. Chart 12Chinese Infrastructure Investment Rising Chinese Infrastructure Investment Rising Chinese Infrastructure Investment Rising Chart 13US Rates Expected To Remain Near Zero Until End 2022 US Rates Expected To Remain Near Zero Until End 2022 US Rates Expected To Remain Near Zero Until End 2022       Footnotes 1     Please see p. 3 of the World Bank’s June 2020 Global Economic Prospects. 2     We proxy US shales using the sum of crude production from the top 5 tight oil basins (i.e. Anadarko, Bakken, Eagle Ford, Niobrara, and Permian). Recent news reports suggest as much as 500k b/d of previously shut-in production will be back on line by the end of the month as a consequence of higher prices. This is slightly above our estimates shown in Chart 4. Please see US shale companies to boost oil output by 500,000 bpd by month-end published June 17, 2020, by reuters.com. 3    Please see A Second Wave Is Now The Base Case (But Stocks Will Eventually Shrug It Off) published by BCA Research’s Global Investment Strategy June 12, 2020. It is available at gis.bcaresearch.com. 4    For a discussion of how options markets price risk – i.e., known economic and political factors with outcomes that can be assigned probabilities – please see Ryan, Bob and Tancred Lidderdale (2009), Energy Price Volatility and Forecast Uncertainty, published by the US EIA October 2009. Risk can be thought of a “known unknowns” that can be measured across time and assigned a probability (conditional or otherwise), while uncertainty literally consists of unknown unknowns that cannot be measured.     Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks

Highlights US dry gas production – the gas traded on futures exchanges and consumed by firms and households – is expected to fall ~ 2.5% this year to 89.7 bcf/d.  Consumption will be down ~ 4% to 74.3 bcf/d.  High carryout stocks from a warmer-than-normal winter mean US natgas storage will be at a record 4 TCF by November.  This is close to demonstrated peak capacity of 4.3 TCF. We expect US benchmark Henry Hub futures prices to average $2.00/MMBtu in 2H20, assuming a normal winter (Chart of the Week).  This is slightly lower than current futures’ levels.  A deeper round of demand destruction from a second wave of COVID-19 remains a risk to commodities generally.  Our base case assumes accommodative policy globally will spur a recovery in gas demand next year.  This will push benchmark US prices into the $2.25-$2.50/MMBtu range, which also is below the level futures currently are trading. Weather-related risk is peaking right now.  The early start to the hurricane season will keep demand for storage gas elevated into October.  Local-distribution companies will be planning for normal winter temperatures, which would be colder than last year. Feature Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. US natgas prices will recover slowly in 2H20 and pick up steam in 2021 as demand recovers and LNG export growth resumes. However, we do not expect prices to rally to the extent futures currently are pricing in, nor as much as the US EIA expects. The NYMEX benchmark natgas futures, which call for delivery of pipeline quality dry gas at Henry Hub, LA, were on track to average close to $2.00/MMBtu this year and $2.64/MMBtu next year earlier this week.1 The EIA, for its part, is forecasting $2.04/MMBtu and $3.08/MMBtu for 2020 and 2021, respectively. Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. Our natgas price models use the EIA’s fundamental inputs – supply, demand and working gas storage levels – and temperature and financial variables to explain and forecast prices, including 10-year average heating-degree days, and US Treasury rates. Chart of the WeekUS Natgas Prices Recover Slowly US Natgas Prices Recover Slowly US Natgas Prices Recover Slowly On the supply side, the rate of growth in US natgas production started rolling over in 4Q19, well before COVID-19 was even an issue for the market. A warmer-than-normal winter last year weakened prices sufficiently to cause natgas production in the US shales to roll over from a high of 86 billion cubic feet per day (bcf/d) in 4Q19, to 84 bcf/d in the first five months of 2020. Shales account for ~ 90% of total US gas production. In and of itself, this is a relatively small impact, reflecting more the unintended inventory accumulation following last winter. Shale-Gas Production Rolls Over The decade-long shale-gas production surge led by the Marcellus formation in the US Appalachian Mountain region and, more recently, the Permian basin in Texas, which together account for ~ 60% of US gas production, ended – for the time being – in 4Q19 (Chart 2). Total natgas production in the Lower 48 states rose 11% in 2019 to 95.6 bcf/d, and is expected to fall ~ 2% this year to 93.7 bcf/d. Chart 2Shale-Gas Production Rolled Over Following A Warm 2019-20 Winter Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Natgas production is sensitive to the level of US short-term rates. The financial variables in our model indicate natgas production is sensitive to the level of US short-term rates, which the Fed has been maintaining at low levels since the Global Financial Crisis (GFC) to battle disinflation. Natgas is a derived demand – it is used to heat buildings and generate electricity, e.g. – so anything that lifts demand will benefit supply (Chart 3). In our modeling, we find natgas production is an explanatory variable for natgas consumption, but not vice versa, suggesting that the supply side is aggressively pricing to meet demand, and increase market share at the expense of coal-fired generation (Chart 4). Chart 3US Natgas Production, Consumption Are Sensitive to US Treasurys US Natgas Production, Consumption Are Sensitive to US Treasurys US Natgas Production, Consumption Are Sensitive to US Treasurys Chart 4Low Rates Accelerate Coal's Market Share Loss To Natgas Low Rates Accelerate Coal's Market Share Loss To Natgas Low Rates Accelerate Coal's Market Share Loss To Natgas Shale-gas production also is being weakened in the US by the collapse in oil prices, particularly in the Permian basin, where associated natural gas output has been surging (Chart 5).2 Close to 500 Bcf of natural gas was flared in the Bakken and Permian plays.3 This means the collapse in crude-oil prices on net is lowering CO2 emissions associated with flaring in Texas and North Dakota.4 Chart 5Associated Gas Production Falls As Crude Oil Prices Weaken Associated Gas Production Falls As Crude Oil Prices Weaken Associated Gas Production Falls As Crude Oil Prices Weaken Chart 6Warm Winter Destroys Natgas Demand Warm Winter Destroys Natgas Demand Warm Winter Destroys Natgas Demand Gas Consumption Growth Slows The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. Gas consumption was hammered by a much warmer-than-average winter last year (Chart 6). This left the level of working gas in storage at ~ 2 TCF by the end of March 2020, when the heating season ended (Chart 7). Natgas working storage has continued to increase every month since, and now stands just below 3 TCF, according to the EIA’s latest estimate. The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. The latest estimate of demonstrated peak storage capacity is 4.26 TCF, which raises the possibility a warm winter this year could lead to a full-storage event.5 Should this happen, markets would begin pricing the probability – not the possibility – of negative natural gas prices in more than just local markets lacking pipeline takeaway capacity or sufficient storage to accommodate local supply and demand imbalances. Chart 7US Working Gas In Storage Continues To Build Toward 4 TCF Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Negative natgas prices would further exacerbate the risk of more sharp curtailments in oil and gas capex – in addition to the $400 billion projected by the International Energy Agency (IEA) last month, which would cut shale-oil and -gas capex by 50%.6 This could set up a huge rally in hydrocarbons generally, oil and gas in particular, should it occur. Beware Disorderly Gas Markets As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. At the end of April, we noted the disorderly termination of trading in WTI futures delivering in May to Cushing, OK, was among the proximate causes of futures falling to -$40.32/bbl – that’s $40.32/bbl below $0.00/bbl – prior to the contract going off the board. Partly, we contend, this was the result of a failure of the US Commodity Futures Trading Commission (CFTC) and the CME Group, which operates WTI crude oil and Henry Hub natgas futures markets, to ensure only bona fide hedgers with the capacity to make or take delivery of the physical commodity being traded via futures contracts were left in the market as these contracts went to delivery. As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. Another failure to ensure an orderly termination of trading would add another impediment to sourcing capital for oil and gas producers – many producers chose to or are forced to hedge – which would exacerbate a tightening of supply in the medium term (2 to 3 years hence). Bottom Line: We expect natgas futures delivering to Henry Hub, LA, to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively, based on our proprietary models using fundamental and financial explanatory variables. Upside risks to the forecast are a stronger-than-expected demand recovery, which sees residential, commercial, industrial and electric-generation demand reviving sharply. A global pick-up that increased demand for LNG also would rally US gas prices sharply. To the downside, another round of demand destruction from a second wave of the COVID-19 pandemic would press prices lower. As US working gas in storage increases, the risks of a full-storage event rises. This will force market participants to price in a higher probability of negative prices, which also would have a deleterious impact on capex and, thus, future supplies.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight US shale E&P companies are bringing back some of their shut-in production as WTI prices remain above $35/bbl. According to Rystad Energy, more than 300k b/d of previously shut-in production is already coming back online as of June. Nonetheless, rig count remains at its lowest level since 2009 and prices are not high enough to incentivize additional drilling. Our estimates suggest the return of shut-in production will pale compared to the drop in production from natural decline rates over the coming months. Base Metals: Neutral In its June Global Economic Prospects, the World Bank revised its emerging market and developing economies real GDP growth estimates for 2020 to -2.5%, a 6.6pp downward revision from its January 2020 projections. On the other hand, China’s credit numbers continue to move up, reaching 30% of nominal GDP in May (Chart 8). Going forward, the recovery in base metals hinges on the speed at which the stimulus reaches the real economy. On average, it takes somewhere between 4 to 9 months for metals to react to surges in China’s TSF. Precious Metals: Neutral Gold prices traded between $1,675/oz and $1,760/oz since April. Our fair-value model suggests prices could trade slightly below this range (Chart 9). However, risks of renewed US-China tensions are rising rapidly, which could keep gold well-bid. BCA Research’s China Investment strategists believe these risks will reach new height over the summer as pressure on Trump’s election campaign intensifies.7 Mounting geopolitical risks could hurt risk assets and benefit gold as a hedge against equity volatility. Ags/Softs:  Underweight July Ethanol futures have shown substantial strength in the past two months, but the outlook remains gloomy. With over 30% of US fuel ethanol plants being idled during the pandemic, as prices and margins increase, an increase in supply is likely.  Gasoline demand might have less room to grow as most individuals keep working from home. Supporting this is EIA’s STEO outlook which sees the ethanol market oversupplied in 2020, with consumption expected to average 800k b/d in 2020 and production to average 880k b/d. Chart 8Chinese Credit Growth To Rise Chinese Credit Growth To Rise Chinese Credit Growth To Rise Chart 9Gold Slightly Above Fair Value Gold Slightly Above Fair Value Gold Slightly Above Fair Value     Footnotes 1     Pipeline-quality dry natural gas has had all impurities (metals, sulfur compounds, etc.) and non-methane liquids removed so that its heat content is ~ 1,010 BTUs per cubic foot. The NYMEX futures taken to delivery at Henry Hub, LA, require physical gas to meet the specifications “set forth in the FERC-approved tariff of Sabine Pipe Line Company.” 2     TThe correlation between US natgas and oil prices declined substantially since 2009. Our model, based on WTI prices and 10-year US treasury yields only, suggests Henry Hub prices’ elasticity to changes in oil prices dropped by more than 50% post-GFC. On the other hand, US yields are now much closely related to natural gas prices. The disconnection between Henry Hub and WTI prices is largely a result of the large increase in shale gas and associated gas production. Strong oil prices –which are determined globally – incentivized higher output by US E&Ps. This led to a surge in the volume of associated gas in an already saturated domestic gas market. 3    Please see Lingering Oil-Demand Weakness Will Fade, which we published November 21, 2019, and discusses flaring in the Permian and Bakken basins. 4    Please see "U.S. oil fields flared and vented more natural gas again in 2019: data" published by reuters.com February 3, 2020. 5    Please see Underground Natural Gas Working Storage Capacity published by the EIA May 29, 2020, for additional detail. 6    Please see The Covid-19 crisis is causing the biggest fall in global energy investment in history, published by the IEA May 27, 2020. The Agency notes, “… after the Covid-19 crisis brought large swathes of the world economy to a standstill in a matter of months, global investment is now expected to plummet by 20%, or almost $400 billion, compared with last year.” Oil and gas investment is projected to fall more than 30%. 7     Please see BCA Research's China Investment Strategy Report entitled Watch Out For A Second Wave (Of US-China Frictions) published June 10, 2010, available at cis.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades Natgas Prices Will Recover Slowly Natgas Prices Will Recover Slowly  

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN Go Long HUF / Short PLN Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Hungary Versus Poland; Colombia Hungary Versus Poland; Colombia Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably The COP Has Depreciated Considerably The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... In 2008, Tech Behaved Like A Cyclical... In 2008, Tech Behaved Like A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend Chart I-10Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Sector Relative Performance Drives... Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance ...Regional And Country Relative Performance ...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP ZAR/CLP ZAR/CLP   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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Pocketing Gains in Oil/Gold Pair Trade Pocketing Gains in Oil/Gold Pair Trade Our reinstated long XOP / short GDX pair trade hit its rolling 10% stop intraday yesterday, forcing us to crystalize 32% gains in just over a month. While our original thesis for this pair trade that was outlined in the April 27th Weekly Report has not changed, we adhere to the risk management tool we put in place and act on our profit-taking stop. We will be looking to reopen this trade later in the summer at a better entry point, especially if as we highlighted on Monday’s Weekly Report the rise in (geo)political risks serve as a catalyst for a much need broad equity market breather. Bottom Line: Crystallize 32% gains in the long XOP / short GDX pair trade, but stay tuned. ​​​​​​​