Currencies

Highlights We are reviewing our recommendations. We are also introducing recommendation tables to monitor these positions. Overall, our main recommendations have generated alpha and have a positive batting average. Feature The end of the month of August offers an opportunity to review the positions recommended in this publication. We introduce three tables corresponding to three investment horizons—tactical, cyclical, and structural—which summarize our main views. Each table is subdivided by asset class, namely equities, fixed income, and currencies. The tables can be found on page 12 and 13 and will be available at the end of future strategy reports. Tactical Recommendations Short Equity Leaders / Long Laggards This position is down 1.4% since inception. The idea behind this bet was that the easy money in the market had been made, and investors needed to become more discerning, although the big-picture economic backdrop continued to favor a pro-cyclical, pro-risk bias in a portfolio. To achieve this goal, we opted to buy cyclicals sectors that had lagged the broad market and to sell the ones that had already overtaken their pre-COVID highs, in the hope of creating a portfolio hedge. Practically, this meant buying sectors such as Industrials, Banks and Energy, while selling sectors such as Capital goods, Autos and Consumer services (Chart 1). This position has not worked out well as yields fell. Chart 1Leaders vs Laggards The Road So Far The Road So Far UK Mid-Cap And Small-Cap To Outperform This position is up 3.4% since inception. We initially favored the more domestically-oriented mid- and small-cap indices in the UK as a bet on the re-opening trade, following the lead taken by the UK in the global vaccination campaign. A faster re-opening would not only boost the ability of smaller domestic firms to generate cash flows, it would also elevate the pound, which would hurt the profit translation of the multinational dominating the UK large-cap indices. By mid-May, we opted to move small cap back to neutral, as the positive story was well discounted and we expected the GBP to correct, which would help large-cap stocks. Favor European Banks Relative To US Ones This position is up 4.1% since inception. It is mainly a value trade. The European economy has lagged behind that of the US, and European yields remain well below US ones. As a result, European financials have greatly underperformed their US counterparts. However, this performance differential has left European banks trading at an enormous discount relative to their US peers. Hence, as continental European economies were catching up to the US on the vaccination front, we expected European banks to regain some ground. This trade has further to go, as valuation differentials remain excessive, especially since European banks are not as risky as they once were. Underweight / Short Norway As Hedge To Swedish Stocks This position is down 1% since inception. We have a cyclical overweight on the Swedish equity market (see page 9), which is extremely sensitive to the global industrial cycle. Thus, we were concerned by the potential near-term impact of the Chinese credit slowdown on this position. Selling Norway remains an appropriate hedge, because this market massively overweight materials stocks, which are even more exposed to the Chinese credit cycle than industrials are. Positive European Small-Cap Stocks This position is up 0.2% since inception. This was a bet on the economic re-opening taking place in the wake of the accelerating pace of vaccination in Europe. However, the weakness in the Euro since May has caused the large-cap European stocks to perform almost as well as their more-domestically focused counterparts. Neutral Stance On Cyclicals Relative To Defensives Chart 2The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance The Cause Of Our Cautious Tactical Stance This trade is up 2.3% since inception. While we like cyclical plays on an eighteen to twenty-four months basis, we became concerned this spring about a tactical pullback. Globally, cyclical stocks had become extremely expensive and overbought relative to defensive sectors (Chart 2). Moreover, the rapid deceleration of the Chinese credit impulse pointed toward a period of negative economic surprises and was historically consistent with a period of underperformance of cyclical names. Now that China is stepping off the brake pedal, this trade is becoming long in the tooth. Neutral Stance On Europe Relative To The Rest of The World This trade is down 0.3% since its inception. This position is a corollary to the neutral view on cyclicals, as European equities possess a high beta. This bet did not pan out; European equities did underperform US stocks, but weaknesses in China and EM undid this benefit. Favoring Industrials Over Materials This trade is up 0.6% since inception. Industrial equities are less exposed to the Chinese credit slowdown than materials, but are more direct beneficiaries of the large infrastructure spending packages being rolled out across advanced economies. Industrials are also a direct bet on a capex recovery, which we expect to intensify over the next two years as companies address supply side issues. The tactical element of this trade may soon dissipate as China’s policy tightening ends, which would warrant booking profits. However, the industrials versus materials theme remains attractive as a cyclical bets on capex. Financials Over Other Cyclicals This trade is down 1.6% since inception. This was another trade aiming to keep some cyclical exposure on the book (long financials), while diminishing the exposure to the Chinese credit slowdown. The fall in yields and the weakness in the euro prevented this trade from working out. We now close this position. Long / Short Basket Based On Combined Mechanical Valuation Indicator This trade is flat since inception. This market-neutral trade uses the methodology developed in our May 31st Special Report in which we introduced our Combined Mechanical Valuation Indicator (CMVI). We bought the most undervalued sectors and sold the most overvalued. We will look to rebalance this portfolio in the coming months. Short Euro Area Energy Stocks / Long UK Energy Stocks Chart 3UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain UK Energy Stocks As A Bargain This trade is up 7.5% since inception. This market neutral trade was fully based on the results from our CMVI (Chart 3). We are taking profits today. Short Consumer Discretionary / Long Telecommunication In Europe This trade is up 10.6% since inception. It is our favored way to express our tactical worries toward cyclical equities and the resulting preference for defensive stocks. Moreover, this trade is attractive from a valuation perspective, as the CMVI gap between discretionary and telecommunication equities is at a record high despite the higher RoE offered by telecom equities (Chart 4). Short Tech / Long Healthcare In Europe This trade is up 9.3% since inception. It is a low-octane version of the short discretionary / long telecommunications position. While it is a short cyclicals / long defensive trade, it does not have the long value / short growth overlay as its higher-octane cousin. However, it is also supported by attractive valuation differentials (Chart 5). Chart 4An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... An Extreme Version Of Short Cyclicals / Long Defensives... Chart 5...and A Lower Octane Expression ...and A Lower Octane Expression ...and A Lower Octane Expression Favor Spain Over France This trade is down 2% since inception. Based on sectoral composition, the Spanish market is more defensive than that of France, which was an appealing characteristic considering our tactical worries for cyclical bets. Moreover, Spanish equities were more attractively priced. However, the Spanish economy has proven less resilient to the Delta variant than that of France. As a result, Spanish financials, which represent a large share of the national benchmark, have suffered. Underweight French Consumer Discretionary Equities Relative To Global Peers This trade is up 0.6% since inception. French discretionary stocks, led by beauty and luxury names, remain attractive structural plays. However, they have become expensive and risk temporarily underperforming their foreign competitors. Buy Swiss Equities / Sell Eurozone Defensive This trade is up 0.5% since inception. Due to their sectoral bias toward consumer staples and healthcare, Swiss equities are extremely defensive. However, they often outperform their Euro Area counterparts when Swiss yields rise relative to those of Germany. We do expect such widening to take place over the coming months. The ECB will continue to expand its balance sheet, which will force the SNB to become increasingly active about putting a floor under EUR/CHF. Historically, these processes boost Swiss stocks relative to Eurozone defensives. Buy European Momentum Stocks / Sell European Growth Stocks Chart 6The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further The Recovery In Momentum Stocks Can Run Further This trade is up 1.7% since inception. In Europe, momentum stocks are exceptionally oversold relative to growth stocks (Chart 6). As yields stabilize, momentum stocks are well placed to outperform growth equities. Moreover, this trade is a careful attempt to begin to move away from our defensive tactical stance as China backs away from policy tightening. More Value Left In European IG This trade is up 0.9% so far. European IG bonds have low spreads, but their breakeven spreads may narrow further as policy remains extremely accommodative and European growth continues to recover, even in the face of the Delta variant. In this context, we see the modest yield pick-up offered by these products as attractive, especially compared to the meagre yields generated by European safe-haven securities. Despite the modest success of the overall recommendation, the country implication did not work out as well. Overweight Italian And Spanish Bonds In Balance Portfolios This trade is up 0.2% since inception. Italian and Spanish government bonds are expensive in absolute terms, but compare well relative to French, Dutch, or German bonds. In a backdrop in which the ECB continues to purchase these instruments, where the NGEU funds create an embryo of fiscal risk-sharing within the EU and where growth is recovering, risk premia in the European periphery have room to decline further. Buy European Steepeners And US Flatteners As A Box Trade Chart 7Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners Buy European Steepeners and US Flatteners This trade is up 63 bps since inception. The ECB will lag behind the Fed, but market pricing already reflects this future. Meanwhile, the terminal policy rate proxy embedded in the EONIA and US OIS curves overstates how high the neutral rate is in the US compared to that of Europe (Chart 7). Thus, as the Fed begins to remove accommodation in the US, the US yield curve should flatten compared to that of Europe. Favor The GBP Over The EUR This trade is up 0.6% since inception. The pound is cheaper than the euro, and the domestic UK economy is well supported by the more advanced re-opening process. This combination will continue to hurt EUR/GBP. Sell EUR/NOK This trade is down 2.6% since inception. The NOK is cheaper than the EUR, and the Norges Bank will lead DM central banks in raising interest rates. Moreover, higher oil prices create a positive term of trade shock in favor of Norway. However, this trade has not worked out so far. Among G-10 currencies, the NOK (along with the SEK) is the most sensitive to the USD’s fluctuations. The rebound in the Greenback since March has therefore hurt this position significantly. Cyclical Recommendations Overweight Stocks Vs Bonds This position is up 7% since inception. European equities follow the global business cycle; while we warned a slowdown would take shape, growth is slated to remain above trend for the foreseeable future. Consequently, while we may adjust tactical positioning to take advantage of these gyrations in growth relative to expectations, our core cyclical view remains to overweight stocks within European balanced portfolios. Overweight Bank Equities Chart 8Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore Euro Area Banks Are Not As Risky Anymore This position is up 2.4% since inception. We have espoused the near-term decline in yields, but our big picture cyclical view remains that yields have more upside globally. An environment in which yields increase is one in which bank profit margins expand, which will in turn boost the relative return of cheap financial equities. Even though the long-term growth rate of bank cash flows warrants a discount, these firms’ valuations also reflect the perception that they carry elevated risks. However, if European NPLs have greatly improved, capital buffers have expanded significantly (Chart 8), and the ECB is unwilling to precipitate a crisis as it did ten years ago. In this context, the risk premia embedded in European bank valuations have room to decrease, which will boost the relative performance of these equities. Bullish German Equities (Absolute) This position is up 3.9% since inception. German stocks are a direct bet on the global economy, as a result of their heavy weighting in industrials and consumer discretionary stocks. Moreover, the German economy continues to fare well, boosted by a cheap euro and a low policy rate. Finally, we expect German fiscal policy to remain accommodative after the upcoming federal election weakens the power of the CDU. This combination will allow German stocks to generate further upside over the coming years. Favor Swedish Equites Over Eurozone And US Benchmarks Since inception, this position is up 0.9% on its European leg and is up 0.3% on its US leg. Sweden is a particularly appealing market despite its demanding valuations. The Swedish benchmark overweighs industrials and financials, two of our favorite sectors for the coming eighteen months. Moreover, the Swedish corporate sector’s operating metrics are robust, with wide profit margins, elevated RoEs, and comparatively healthy levels of leverage. Finally, the SEK is one of our favored currencies on a twenty-four-month basis, because it has a strong beta to the USD, which BCA expects to depreciate on a cyclical time frame. Buying Sweden versus the Eurozone has worked out, but selling the US market has not, because yields experienced a countertrend decline. Once global yields begin to rise anew and Chinese credit growth begins to recover, Swedish equities should also beat their US peers. Long Swedish Industrials / Short Eurozone And US Industrials Chart 9Favor Swedish Industrials Favor Swedish Industrials Favor Swedish Industrials This position is up 3% on its European leg and 8.5% on its US one. This market neutral position narrows in on the very reason to favor Swedish equities: industrials. As is the case for the overall market, Swedish industrials offer stronger operating metrics than their counterparts in both the Eurozone and the US (Chart 9). Additionally, the early positioning of Sweden in global supply chains adds some operating leverage to these firms, which gives them an advantage in an environment of continued inventory rebuilding, infrastructure spending, and capex plans around the world. Underweight German Bunds Within European Fixed-Income Portfolios German bund yields have declined 15bps since inception. German Bunds suffer from their extremely demanding valuations versus other European fixed-income securities. As long as global and European growth remains above trend, German yields should underperform other European fixed-income assets, even if the ECB stands pat for the foreseeable future (which would force greater spread compression across European markets). Weakness In EUR/USD Creates Long-Term Buying Opportunities Earlier this spring, we expected the dollar to experience a counter-trend bounce as a result of skewed positioning and the potential for a decline in global growth surprises. However, BCA’s cyclical view calls for a weaker USD because of the US balance of payments deficit, the greater tolerance of the Fed for higher inflation, and the overvaluation of the Greenback. Based on these diverging forces, we continue to recommend investors use the current episode of weakness in EUR/USD as an opportunity to garner more exposure to the euro. Short EUR/SEK This position is down 0.6% since inception. The SEK is even more sensitive to the dollar’s gyration than the euro. Moreover, beyond some near-term disappointment in global economic activity, we expect global growth to remain generally robust over the coming eighteen months. This combination will allow the SEK to appreciate versus the EUR, especially when Sweden’s domestic economic activity and asset markets are stronger than that of the Eurozone. Structural Recommendations A Structural Underweight On European Financial Chart 10Too Much Capital Too Much Capital Too Much Capital This long-term position is at odds with our near-term optimism about the sector. However, Europe has an excessively large capital stock, which, relative to GDP, dwarves that of the US or China (Chart 10). This phenomenon hurts rate of returns across the region and will remain a long-term structural handicap for the financial industry. Hence, investors with long investment horizons should use the expected rebound in European financials over the next year or two to diminish further their exposure to that sector. Norwegian Equities Remain Challenged As Long-Term Holdings Norwegian stocks overweight the financials, materials, and energy sectors. While materials face a bright future as electricity becomes an even more important component of the global energy mix, financials and energy face deep structural headwinds. Moreover, the krone faces its own structural challenges (see below). This combination augurs poorly for the long-term rates of return of Norwegian stocks. Overweight French Industrials Relative To German Ones This position is a bet on the continuation of the reform efforts of the French economy. BCA expects Emmanuel Macron to win a second mandate next year, which should result in additional reforms to the French economy. As a result, the French unit labor costs should remain contained relative to those of Germany. This process will help the profit margins of French industrial firms relative to that of their competitors across the Rhine. Overweight French Tech Equities Relative To European Ones French tech stocks will benefit from the greater R&D subsidies and budgets promoted by the French government. The Euro Will Underperform Pro-Cyclical European Currencies The Swedish krona and the British pound are particularly attractive versus the euro on a long-term basis. They benefit not only from their cheaper valuations, but also from the fact that the Riksbank and the Bank of England will tighten policy considerably ahead of the ECB. Additionally, the SEK and the GBP are now both more pro-cyclical than the euro. The Norwegian Krone Faces Structural Challenges The NOK is cheap and may even benefit in the coming month from its historical pro-cyclicality. However, Norway suffers from declining productivity relative to that of its trading partners, which creates a strong long-term handicap for its currency. As a result, long-term investors should withdraw from the NOK.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations The Road So Far The Road So Far Cyclical Recommendations The Road So Far The Road So Far Structural Recommendations The Road So Far The Road So Far ​​​​​​​ Currency Performance Fixed Income Performance Equity Performance  

Highlights The US dollar’s reserve status will remain intact for the foreseeable future. While this privilege is fraying at the edges, there are no viable alternatives just yet. There is an overarching incentive for any country to hold onto its currency’s power. For the US, it is still well within their ability to keep this “exorbitant privilege.” That said, there will be rolling doubts about the ability of the US to maintain its large currency sphere. This will create tidal waves in the currency’s path, providing plenty of trading opportunities for investors. China is on track to surpass the US in economic size, but it is far from dethroning the US in the military realm. However, it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Watch the RMB over the next few decades. From a macro and cyclical perspective, the dollar is likely to decline as global growth picks up and the Fed lags market expectations in raising rates. From a geopolitical perspective, however, the backdrop is neutral-to-bullish for the dollar over the next three to five years. Feature Having the world’s reserve currency comes with a few advantages, which any governments would be loath to give up. The most important advantage is the ability to settle one’s balance of payments in one’s own currency. This not only facilitates trade for the reserve nation, it also reinforces the turnover of the reserve currency internationally. The value of this privilege is as much symbolic as economic. This “first mover advantage” or adoption of one’s currency internationally automatically ordains the resident central bank as the world’s bank. The primary advantage here is being able to dictate global financial conditions, expanding and contracting money supply to address domestic and global funding pressures. As compensation for this task, the world provides one with non-negligible seigniorage revenue. Being the world’s central bank also comes with another crucial advantage: being able to choose which international projects will be funded, while using cheaply issued local debt to finance these investments. Of course, any sensible society will earn more on its investments than it pays on the debt issued. There is a geopolitical angle to having the world’s reserve currency. A nation’s currency is widely held because of strategic depth—its ability to secure the people who trade in that currency and the property denominated in it. Deposits and transactions can be monitored, secured, or even halted at the behest of the sovereign. Holding the currency means one can maintain one’s purchasing power, given that it is backed by the most powerful country in the world. As the reserve currency becomes the de facto international medium of exchange, having stood the test of time through various crises, this allows the resident country to alter its purchasing power to achieve both national and international goals. Throughout history, having the world’s reserve currency has been the pursuit of many governments and kingdoms. In the current paradigm, the US enjoys this privilege. But could that change? And if so, how and when? Our goal in this report is threefold. First, why would any country want to maintain reserve status? Second, does the US still possess the apparatus to keep the dollar as a reserve asset over the next decade? And finally, are there any identifiable threats to the US dollar reserve status beyond a ten-year horizon? The Imperative To Maintain Status Quo Global trade is still largely conducted in US dollars. According to the BIS triennial central bank survey, 88.3% of transactions globally were in dollars just before the pandemic, a percentage that has been rather resilient over the last two decades (Chart I-1). It is true that currencies such as the Chinese renminbi have been gaining international acceptance, but displacing a currency that dominates almost 90% of global transactions is a herculean task. Surprisingly, the world has been transacting less often in euros and Japanese yen, currencies that also commanded international appeal in recent history. Chart I-1The US Dollar Still Dominates Global Transactions Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The big benefit for the US comes from being able to settle its balance of payments in dollars. This not only lowers transaction costs (by lowering exchange rate risk), but it also provides the ability to cheaply borrow in your own currency to pay for imports. Having global trade largely denominated in US dollars also establishes a network of systems that make it much easier to settle trade in that currency. It is remarkable that, despite running a persistent current account deficit, the US dollar has tended to appreciate during crises, a privilege other deficit countries do not enjoy (Chart I-2). Strong network effects make the US dollar the currency of choice during crises. Chart I-2Despite Running A Current Account Deficit, The Dollar Tends To Rise During Crises Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-3The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue Being at the center of the global financial architecture comes with an important benefit beyond trade: the ability to dictate financial conditions both domestically and globally. Consider a scenario in which the US and the global economy are facing a downturn. In this scenario, the Federal Reserve can be instrumental in turning the tide: To stimulate the US economy, the Fed lowers interest rates and/or runs a wider fiscal deficit. The central bank helps finance this fiscal deficit by expanding the monetary base (benefitting from seigniorage revenue). As the Fed drops interest rates, the yield curve steepens. Banks use the positive term structure to borrow at the short end of the curve and lend at the longer end. This boosts the US money supply. As firms borrow to invest, this increases demand for imports (machinery, commodities, consumer goods), widening the US current account deficit. US trade is settled in dollars, increasing the international supply of the greenback. To maintain competitiveness, other central banks purchase these dollars from the private sector, in exchange for their local currency. As global USD reserves rise, they can be reinvested back into Treasuries and held in custody at the Fed. In essence, the US can finance its budget deficit through a strong capital account surplus. The seigniorage revenue that the US enjoys by easing both domestic and international financing conditions is about $100 billion a year or roughly 0.5% of GDP (Chart I-3). But the goodwill from being able to dictate both domestic and international financial conditions is far greater. At BCA, one of our favorite measures of global dollar liquidity is the sum of the Fed’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a financial crisis somewhere, typically among other countries running deficits (Chart I-4), a highlight of the importance of the US as a global financier. Chart I-4US Money Supply And Global Liquidity US Money Supply And Global Liquidity US Money Supply And Global Liquidity Chart I-5Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Beyond seigniorage revenue, the US enjoys another advantage—being able to earn much more on its international investments than it pays on its liabilities. The US generates an excess return of 1% of GDP from its external assets, despite having a net liability shortfall of 67% of GDP (Chart I-5). The ability to issue debt that will be gobbled up by foreigners, and in part use these proceeds to generate a higher overall return on investments made abroad, does indeed constitute an “exorbitant privilege.” In a nutshell, there is a very strong incentive for the US to keep the dollar as the world’s reserve currency. One short-term implication is that the Fed might only taper asset purchases and/or raise interest rates in an environment in which both global and US growth are strong, or it could otherwise trigger a global liquidity crisis. This will be particularly the case given the Delta variant of COVID-19 is still hemorrhaging global economic activity. An Overreach In The Dollar’s Influence There is a political advantage to the US dollar’s reserve status that is often overlooked: transactions conducted in US dollars anywhere in the world fall under US law. In simple terms, if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Since most companies across the world cannot afford to be locked out of the US financial system, they will tend to comply with US sanctions. Even companies that operate under the umbrella of great powers, such as China and Russia, still tend to adhere to US sanctions, because they do not want to jeopardize their trade with US allies, such as the European Union. Of course, China, Russia, and Iran are actively seeking alternative transaction systems to bypass the dollar and US sanctions. But they do not yet trust each other’s currencies. Chart I-6A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys The euro is the only viable alternative; however, the euro’s share of global transactions has fallen, despite the EU’s solidification as a monetary union over the past decade and despite the unprecedented deterioration of US relations with China and Russia. The EU could do great damage to the USD’s standing if it joined Russia’s and China’s efforts wholeheartedly, but the EU is still a major trading partner of the US and shares many of the same foreign policy aims. It is also chronically short of aggregate demand and runs trade and current account surpluses, depriving trade partners of euro savings or a debt market to recycle those savings (Chart I-6). Historically, having the world’s reserve currency allows the US to conduct international accords that serve both domestic and foreign interests. The Plaza Accord, signed in the 1980s to depreciate the US dollar, served both US interests in rebalancing the deficit and international interests in financing global trade. The 1980s were golden years for Japan and the Asian tigers on the back of a weak USD, allowing entities to borrow in greenbacks and profitably invest in Asian growth. Once the US dollar had depreciated by a fair amount, threatening its store of value, the US engineered the Louvre Accord to stabilize exchange rates. Ultimately, when various Asian bubbles popped, investors thought of nowhere better to flee than to the safety of the US dollar. The same thing happened after the emerging market boom of the 2000s and the eventual bust of the 2010s. Today, the US may not be able to organize an international intervention, if one should be necessary in the coming years. Past experience shows that countries act unilaterally and coordinated interventions lack staying power. Neither Europe nor Japan is in the position today to allow currency appreciation, as they were in the past. And the US has shown itself unable to combat its trading partners’ depreciation, as in the case of China, whose renminbi remains below 2014 levels. The bottom line is that there is nothing to stop the US from attempting to stretch its overreach too far, which would create a backlash that diminishes the dollar’s status. This is especially the case given trust in the US government is quite low by historical standards, which for now points to a lower dollar cyclically (Chart I-7). Chart I-7Trust In The US Government And The Dollar Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? This is not to say that other countries with reserve aspirations can tolerate sustained appreciation. China has recommitted to manufacturing supremacy in its latest five-year plan, as it fears the political consequences of rapid deindustrialization. As such, the renminbi will be periodically capped to maintain competitiveness. Can The US Maintain Status Quo? Chart I-8A Lifespan Of Reserve Currencies Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Over the last few centuries, reserve currencies have tended to have a lifespan of about 100 years (Chart I-8). The reason is that global wars tend to knock the leading power off its geopolitical pedestal, devaluing its currency and giving rise to a new peace settlement with a new ascendant country whose currency then becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. Granting that the US dollar took the baton from sterling in the 1920s and that the post-World War II peace settlement is eroding in the face of escalating geopolitical competition, it is reasonable to ask whether or not the US might lose its grip on this power. To assess this possibility, it is instructive to revisit the anatomy of a reserve currency: Typically, a reserve currency tends to be that of the “greatest” nation. For the same reason, the reserve nation tends to be the wealthiest, which ensures that its currency is a store of value and that it can act as a buyer of last resort during crisis (Chart I-9). This reasoning is straightforward when a global empire is recognizable and unopposed. But in the current context of multipolarity, or great power competition, the paradigm could start to shift. Global trade is slowing globally, but it is accelerating in Asia (Chart I-10). China is a larger trading partner than the US for many emerging markets and is slated to surpass the US economy over the next decade. The renminbi has a long way to go to rival the dollar, but it is gradually rising and its place within the global reserve currency basket is much smaller than its share of global trade or output, implying room for growth (Chart I-11). Chart I-9Wealth And Reserve Currency Status Go Hand-In-Hand Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-10Trade In Asia Is Booming Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-11Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow To maintain hegemonic power (especially controlling the vital supply routes of prosperity), the reserve nation needs military might above and beyond everyone else. It helps that US military spending remains the biggest in the world, in part financed by US liabilities (Chart I-12). China is far from dethroning the US in the military realm. But it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Moreover, its naval power is set to grow substantially between now and 2030 (Table I-1). Already, over the past decade, the US stood helplessly by when Russia and China annexed Crimea and the reefs of the South China Sea. It is possible to imagine a series of events that erode US security guarantees in the region, even as the US loses economic primacy. Chart I-12The US Still Maintains Military Might Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Table I-1China’s Economic And Naval Growth Slated To Reduce American Primacy In Asia Pacific Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The reserve currency nation needs to run deficits to finance activity in the rest of the world. That requires having deep and liquid capital markets to absorb global savings. There is considerable trust or “goodwill” that makes the US Treasury market the most liquid debt exchange pool in the world. This remains the case today (previously mentioned Chart I-6). Even so, this trend is shifting. The growth in euro- and yen-denominated debt is exploding. This mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the US began to use the dollar as a geopolitical weapon recklessly, foreign entities may have no other choice but to rally into other currency blocks, including the euro (and perhaps eventually the yuan). This will take years, but it is worth noting that global allocation to FX reserves have fallen from around 80% toward USDs in the 70s to around 60% today (Chart I-13). Chart I-13The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing On the political front, there is some evidence that public opinion on the dollar is fading, although it is far from damning. A Pew survey on the trust in the US government is near decade lows and has tracked the ebb and flow of changes in the dollar (previously shown Chart I-7). Trust in government will probably not get much worse in the coming years, as the pandemic will wane and stimulus will secure the economic recovery, but too much stimulus could conceivably ignite an inflation problem that weighs on trust. True, populism has driven the US government under two administrations into extreme deficit spending. With the pandemic as a catalyst, US deficits have reached WWII levels despite the absence of a war. However, the Biden administration’s $3.5 trillion spending bill will be watered down heavily – and the 2022 midterms will likely restore gridlock in Congress, freezing fiscal policy through at least 2025. In other words, fiscal policy is negative for the dollar in the very near term, but the fiscal outlook is not yet so extravagant as to suggest a loss of reserve currency status. After all, there is some positive news for the US. The US demonstrated its leadership in innovation with the COVID-19 vaccines; it survived its constitutional stress test in the 2020 election; it is now shifting from failed “nation building” abroad to nation building at home; and its companies remain the most innovative and efficient, judging by global equity market capitalization (Chart I-14). China, meanwhile, is facing the most severe test of its political and economic system since it marketized its economy in 1979. Investors should not lose sight of the fact that, since the rise of President Xi Jinping and Russia’s invasion of Ukraine, global policy uncertainty has tended to outpace US policy uncertainty, attracting flows into the dollar (Chart I-15). Given that China and Russia are both pursuing autocratic governments at the expense of the private economy, it would not be surprising to see global policy uncertainty take the lead once again, confirming the decade trend of global flows favoring the US when uncertainty rises. Chart I-14American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market Chart I-15Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar The bottom line is that the US dollar is gradually declining as a share of the global currency reserve basket, just as the US economy and military are gradually declining as a share of global output and defense spending. Yet the US will remain the first or second largest economy and premier military power for a long time, and the dollar still lacks a viable single replacement. A major war or geopolitical crisis is probably necessary to precipitate a major breakdown. The Iranian Revolution and September 11 attacks both had this kind of effect (see 1979 and 2001 in Chart I-13 above). But COVID-19 is less clear. If China and Europe emerge as more stable than the US, then the post-pandemic aftermath will bring more bad news for the dollar. Investment Implications From a geopolitical perspective, the backdrop is neutral for the dollar beyond the next twelve to eighteen months. An escalating conflict with Iran—which is possible in the near term—would echo the early 2000s and weigh on the currency. But a deal with Iran and a strategic pivot to Asia would compound China’s domestic political problems and likely boost the greenback. Chart I-16US Twin Deficits And The Dollar US Twin Deficits And The Dollar US Twin Deficits And The Dollar From a macro and cyclical perspective, however, the view is clearly negative for the dollar. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will shrink and then begin expanding again to -5% of GDP. If one assumes that the current account deficit will widen somewhat, then stabilize, the twin deficits will be pinned at around -10% of GDP. Markets have typically punished the dollar on rising twin deficits (Chart I-16). This suggests near-term pressure on the dollar’s reserve status is to the downside. EM currencies may hold a key to the performance of the dollar. While most EM economies remain hostage to the virus, a coiled-spring rebound cannot be ruled out as populations become vaccinated. China’s Politburo signaled in July that it will no longer tighten monetary and fiscal policy. We would expect policy easing over the next twelve months to ensure the economy is stable in advance of the fall 2022 party congress. If the virus wanes and China’s economy is stimulated, global growth will improve and the dollar will fall.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com

Highlights The US dollar’s reserve status will remain intact for the foreseeable future. While this privilege is fraying at the edges, there are no viable alternatives just yet. There is an overarching incentive for any country to hold onto its currency’s power. For the US, it is still well within their ability to keep this “exorbitant privilege.” That said, there will be rolling doubts about the ability of the US to maintain its large currency sphere. This will create tidal waves in the currency’s path, providing plenty of trading opportunities for investors. China is on track to surpass the US in economic size, but it is far from dethroning the US in the military realm. However, it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Watch the RMB over the next few decades. From a macro and cyclical perspective, the dollar is likely to decline as global growth picks up and the Fed lags market expectations in raising rates. From a geopolitical perspective, however, the backdrop is neutral-to-bullish for the dollar over the next three to five years. Feature Having the world’s reserve currency comes with a few advantages, which any governments would be loath to give up. The most important advantage is the ability to settle one’s balance of payments in one’s own currency. This not only facilitates trade for the reserve nation, it also reinforces the turnover of the reserve currency internationally. The value of this privilege is as much symbolic as economic. This “first mover advantage” or adoption of one’s currency internationally automatically ordains the resident central bank as the world’s bank. The primary advantage here is being able to dictate global financial conditions, expanding and contracting money supply to address domestic and global funding pressures. As compensation for this task, the world provides one with non-negligible seigniorage revenue. Being the world’s central bank also comes with another crucial advantage: being able to choose which international projects will be funded, while using cheaply issued local debt to finance these investments. Of course, any sensible society will earn more on its investments than it pays on the debt issued. There is a geopolitical angle to having the world’s reserve currency. A nation’s currency is widely held because of strategic depth—its ability to secure the people who trade in that currency and the property denominated in it. Deposits and transactions can be monitored, secured, or even halted at the behest of the sovereign. Holding the currency means one can maintain one’s purchasing power, given that it is backed by the most powerful country in the world. As the reserve currency becomes the de facto international medium of exchange, having stood the test of time through various crises, this allows the resident country to alter its purchasing power to achieve both national and international goals. Throughout history, having the world’s reserve currency has been the pursuit of many governments and kingdoms. In the current paradigm, the US enjoys this privilege. But could that change? And if so, how and when? Our goal in this report is threefold. First, why would any country want to maintain reserve status? Second, does the US still possess the apparatus to keep the dollar as a reserve asset over the next decade? And finally, are there any identifiable threats to the US dollar reserve status beyond a ten-year horizon? The Imperative To Maintain Status Quo Global trade is still largely conducted in US dollars. According to the BIS triennial central bank survey, 88.3% of transactions globally were in dollars just before the pandemic, a percentage that has been rather resilient over the last two decades (Chart I-1). It is true that currencies such as the Chinese renminbi have been gaining international acceptance, but displacing a currency that dominates almost 90% of global transactions is a herculean task. Surprisingly, the world has been transacting less often in euros and Japanese yen, currencies that also commanded international appeal in recent history. Chart I-1The US Dollar Still Dominates Global Transactions Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The big benefit for the US comes from being able to settle its balance of payments in dollars. This not only lowers transaction costs (by lowering exchange rate risk), but it also provides the ability to cheaply borrow in your own currency to pay for imports. Having global trade largely denominated in US dollars also establishes a network of systems that make it much easier to settle trade in that currency. It is remarkable that, despite running a persistent current account deficit, the US dollar has tended to appreciate during crises, a privilege other deficit countries do not enjoy (Chart I-2). Strong network effects make the US dollar the currency of choice during crises. Chart I-2Despite Running A Current Account Deficit, The Dollar Tends To Rise During Crises Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-3The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue The US Generates Non-Negligible Seignorage Revenue Being at the center of the global financial architecture comes with an important benefit beyond trade: the ability to dictate financial conditions both domestically and globally. Consider a scenario in which the US and the global economy are facing a downturn. In this scenario, the Federal Reserve can be instrumental in turning the tide: To stimulate the US economy, the Fed lowers interest rates and/or runs a wider fiscal deficit. The central bank helps finance this fiscal deficit by expanding the monetary base (benefitting from seigniorage revenue). As the Fed drops interest rates, the yield curve steepens. Banks use the positive term structure to borrow at the short end of the curve and lend at the longer end. This boosts the US money supply. As firms borrow to invest, this increases demand for imports (machinery, commodities, consumer goods), widening the US current account deficit. US trade is settled in dollars, increasing the international supply of the greenback. To maintain competitiveness, other central banks purchase these dollars from the private sector, in exchange for their local currency. As global USD reserves rise, they can be reinvested back into Treasuries and held in custody at the Fed. In essence, the US can finance its budget deficit through a strong capital account surplus. The seigniorage revenue that the US enjoys by easing both domestic and international financing conditions is about $100 billion a year or roughly 0.5% of GDP (Chart I-3). But the goodwill from being able to dictate both domestic and international financial conditions is far greater. At BCA, one of our favorite measures of global dollar liquidity is the sum of the Fed’s custody holdings together with the US monetary base. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a financial crisis somewhere, typically among other countries running deficits (Chart I-4), a highlight of the importance of the US as a global financier. Chart I-4US Money Supply And Global Liquidity US Money Supply And Global Liquidity US Money Supply And Global Liquidity Chart I-5Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Despite A Liability Shortfall, US Assets Generate A Net Profit Beyond seigniorage revenue, the US enjoys another advantage—being able to earn much more on its international investments than it pays on its liabilities. The US generates an excess return of 1% of GDP from its external assets, despite having a net liability shortfall of 67% of GDP (Chart I-5). The ability to issue debt that will be gobbled up by foreigners, and in part use these proceeds to generate a higher overall return on investments made abroad, does indeed constitute an “exorbitant privilege.” In a nutshell, there is a very strong incentive for the US to keep the dollar as the world’s reserve currency. One short-term implication is that the Fed might only taper asset purchases and/or raise interest rates in an environment in which both global and US growth are strong, or it could otherwise trigger a global liquidity crisis. This will be particularly the case given the Delta variant of COVID-19 is still hemorrhaging global economic activity. An Overreach In The Dollar’s Influence There is a political advantage to the US dollar’s reserve status that is often overlooked: transactions conducted in US dollars anywhere in the world fall under US law. In simple terms, if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Since most companies across the world cannot afford to be locked out of the US financial system, they will tend to comply with US sanctions. Even companies that operate under the umbrella of great powers, such as China and Russia, still tend to adhere to US sanctions, because they do not want to jeopardize their trade with US allies, such as the European Union. Of course, China, Russia, and Iran are actively seeking alternative transaction systems to bypass the dollar and US sanctions. But they do not yet trust each other’s currencies. Chart I-6A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys A Deep And Liquid Pool Of Treasurys The euro is the only viable alternative; however, the euro’s share of global transactions has fallen, despite the EU’s solidification as a monetary union over the past decade and despite the unprecedented deterioration of US relations with China and Russia. The EU could do great damage to the USD’s standing if it joined Russia’s and China’s efforts wholeheartedly, but the EU is still a major trading partner of the US and shares many of the same foreign policy aims. It is also chronically short of aggregate demand and runs trade and current account surpluses, depriving trade partners of euro savings or a debt market to recycle those savings (Chart I-6). Historically, having the world’s reserve currency allows the US to conduct international accords that serve both domestic and foreign interests. The Plaza Accord, signed in the 1980s to depreciate the US dollar, served both US interests in rebalancing the deficit and international interests in financing global trade. The 1980s were golden years for Japan and the Asian tigers on the back of a weak USD, allowing entities to borrow in greenbacks and profitably invest in Asian growth. Once the US dollar had depreciated by a fair amount, threatening its store of value, the US engineered the Louvre Accord to stabilize exchange rates. Ultimately, when various Asian bubbles popped, investors thought of nowhere better to flee than to the safety of the US dollar. The same thing happened after the emerging market boom of the 2000s and the eventual bust of the 2010s. Today, the US may not be able to organize an international intervention, if one should be necessary in the coming years. Past experience shows that countries act unilaterally and coordinated interventions lack staying power. Neither Europe nor Japan is in the position today to allow currency appreciation, as they were in the past. And the US has shown itself unable to combat its trading partners’ depreciation, as in the case of China, whose renminbi remains below 2014 levels. The bottom line is that there is nothing to stop the US from attempting to stretch its overreach too far, which would create a backlash that diminishes the dollar’s status. This is especially the case given trust in the US government is quite low by historical standards, which for now points to a lower dollar cyclically (Chart I-7). Chart I-7Trust In The US Government And The Dollar Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? This is not to say that other countries with reserve aspirations can tolerate sustained appreciation. China has recommitted to manufacturing supremacy in its latest five-year plan, as it fears the political consequences of rapid deindustrialization. As such, the renminbi will be periodically capped to maintain competitiveness. Can The US Maintain Status Quo? Chart I-8A Lifespan Of Reserve Currencies Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Over the last few centuries, reserve currencies have tended to have a lifespan of about 100 years (Chart I-8). The reason is that global wars tend to knock the leading power off its geopolitical pedestal, devaluing its currency and giving rise to a new peace settlement with a new ascendant country whose currency then becomes the basis for international trade. Such was the case for Spain, France, the UK, and the United States in a pattern of war and peace since the sixteenth century. Granting that the US dollar took the baton from sterling in the 1920s and that the post-World War II peace settlement is eroding in the face of escalating geopolitical competition, it is reasonable to ask whether or not the US might lose its grip on this power. To assess this possibility, it is instructive to revisit the anatomy of a reserve currency: Typically, a reserve currency tends to be that of the “greatest” nation. For the same reason, the reserve nation tends to be the wealthiest, which ensures that its currency is a store of value and that it can act as a buyer of last resort during crisis (Chart I-9). This reasoning is straightforward when a global empire is recognizable and unopposed. But in the current context of multipolarity, or great power competition, the paradigm could start to shift. Global trade is slowing globally, but it is accelerating in Asia (Chart I-10). China is a larger trading partner than the US for many emerging markets and is slated to surpass the US economy over the next decade. The renminbi has a long way to go to rival the dollar, but it is gradually rising and its place within the global reserve currency basket is much smaller than its share of global trade or output, implying room for growth (Chart I-11). Chart I-9Wealth And Reserve Currency Status Go Hand-In-Hand Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-10Trade In Asia Is Booming Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Chart I-11Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow Adoption Of The RMB Has Room To Grow To maintain hegemonic power (especially controlling the vital supply routes of prosperity), the reserve nation needs military might above and beyond everyone else. It helps that US military spending remains the biggest in the world, in part financed by US liabilities (Chart I-12). China is far from dethroning the US in the military realm. But it is gradually gaining the ability to deny the US access to its immediate offshore areas and may already be capable of winning a war over nearby islands like Taiwan. Moreover, its naval power is set to grow substantially between now and 2030 (Table I-1). Already, over the past decade, the US stood helplessly by when Russia and China annexed Crimea and the reefs of the South China Sea. It is possible to imagine a series of events that erode US security guarantees in the region, even as the US loses economic primacy. Chart I-12The US Still Maintains Military Might Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? Table I-1China’s Economic And Naval Growth Slated To Reduce American Primacy In Asia Pacific Is The Dollar’s Reserve Status Under Threat? Is The Dollar’s Reserve Status Under Threat? The reserve currency nation needs to run deficits to finance activity in the rest of the world. That requires having deep and liquid capital markets to absorb global savings. There is considerable trust or “goodwill” that makes the US Treasury market the most liquid debt exchange pool in the world. This remains the case today (previously mentioned Chart I-6). Even so, this trend is shifting. The growth in euro- and yen-denominated debt is exploding. This mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the US began to use the dollar as a geopolitical weapon recklessly, foreign entities may have no other choice but to rally into other currency blocks, including the euro (and perhaps eventually the yuan). This will take years, but it is worth noting that global allocation to FX reserves have fallen from around 80% toward USDs in the 70s to around 60% today (Chart I-13). Chart I-13The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing The Dollar Reserve Status Has Been Ebbing On the political front, there is some evidence that public opinion on the dollar is fading, although it is far from damning. A Pew survey on the trust in the US government is near decade lows and has tracked the ebb and flow of changes in the dollar (previously shown Chart I-7). Trust in government will probably not get much worse in the coming years, as the pandemic will wane and stimulus will secure the economic recovery, but too much stimulus could conceivably ignite an inflation problem that weighs on trust. True, populism has driven the US government under two administrations into extreme deficit spending. With the pandemic as a catalyst, US deficits have reached WWII levels despite the absence of a war. However, the Biden administration’s $3.5 trillion spending bill will be watered down heavily – and the 2022 midterms will likely restore gridlock in Congress, freezing fiscal policy through at least 2025. In other words, fiscal policy is negative for the dollar in the very near term, but the fiscal outlook is not yet so extravagant as to suggest a loss of reserve currency status. After all, there is some positive news for the US. The US demonstrated its leadership in innovation with the COVID-19 vaccines; it survived its constitutional stress test in the 2020 election; it is now shifting from failed “nation building” abroad to nation building at home; and its companies remain the most innovative and efficient, judging by global equity market capitalization (Chart I-14). China, meanwhile, is facing the most severe test of its political and economic system since it marketized its economy in 1979. Investors should not lose sight of the fact that, since the rise of President Xi Jinping and Russia’s invasion of Ukraine, global policy uncertainty has tended to outpace US policy uncertainty, attracting flows into the dollar (Chart I-15). Given that China and Russia are both pursuing autocratic governments at the expense of the private economy, it would not be surprising to see global policy uncertainty take the lead once again, confirming the decade trend of global flows favoring the US when uncertainty rises. Chart I-14American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market American Primacy Still Clear In Equity Market Chart I-15Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar Higher Policy Uncertainty Good For Dollar The bottom line is that the US dollar is gradually declining as a share of the global currency reserve basket, just as the US economy and military are gradually declining as a share of global output and defense spending. Yet the US will remain the first or second largest economy and premier military power for a long time, and the dollar still lacks a viable single replacement. A major war or geopolitical crisis is probably necessary to precipitate a major breakdown. The Iranian Revolution and September 11 attacks both had this kind of effect (see 1979 and 2001 in Chart I-13 above). But COVID-19 is less clear. If China and Europe emerge as more stable than the US, then the post-pandemic aftermath will bring more bad news for the dollar. Investment Implications From a geopolitical perspective, the backdrop is neutral for the dollar beyond the next twelve to eighteen months. An escalating conflict with Iran—which is possible in the near term—would echo the early 2000s and weigh on the currency. But a deal with Iran and a strategic pivot to Asia would compound China’s domestic political problems and likely boost the greenback. Chart I-16US Twin Deficits And The Dollar US Twin Deficits And The Dollar US Twin Deficits And The Dollar From a macro and cyclical perspective, however, the view is clearly negative for the dollar. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will shrink and then begin expanding again to -5% of GDP. If one assumes that the current account deficit will widen somewhat, then stabilize, the twin deficits will be pinned at around -10% of GDP. Markets have typically punished the dollar on rising twin deficits (Chart I-16). This suggests near-term pressure on the dollar’s reserve status is to the downside. EM currencies may hold a key to the performance of the dollar. While most EM economies remain hostage to the virus, a coiled-spring rebound cannot be ruled out as populations become vaccinated. China’s Politburo signaled in July that it will no longer tighten monetary and fiscal policy. We would expect policy easing over the next twelve months to ensure the economy is stable in advance of the fall 2022 party congress. If the virus wanes and China’s economy is stimulated, global growth will improve and the dollar will fall.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com

This week I have been holding client calls and roundtables with clients located in the EMEA region. In next week’s report we will share our answers to the most common client questions. In the meantime, this week we are sending you a report about Peru that discusses the political situation and the outlook for the nation’s financial markets. Best regards, Arthur Budaghyan Highlights Do not bottom fish in Peruvian financial markets. Political volatility has not yet reached its apex. Clashes between the government and congress are inevitable. Either president Pedro Castillo will be impeached and massive protest will follow, or his party’s radical leftist agenda will be at least partially legislated. Neither scenario bodes well for Peru’s financial markets. Capital outflows and lower metal prices pose a threat to the exchange rate. Go short the sol versus the US dollar. Dedicated EM equity and fixed-income managers should continue underweighting Peru in their respective portfolios. Feature Chart 1Peru: Absolute And Relative Equity Performance Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Peru’s financial assets have plummeted due to the election of left-wing president Pedro Castillo. Some investors may be tempted to bottom fish in these markets due to their lower valuations and oversold conditions (Chart 1, top panel). Some may attempt to draw parallels with Brazil’s 2002 election of Lula da Silva which initially triggered a selloff in Brazilian financial markets followed by a substantial rally during the president’s two terms in office. Will that be the case with Peruvian markets? We do not think so. Unlike twenty years ago in Brazil, Peru is currently facing a much worse political and economic outlook. Overall, the political volatility as well as deteriorating macro fundamentals warrant a higher risk premium on Peruvian assets. Thus, we recommend investors underweight Peru within EM equity, local, and sovereign fixed-income portfolios (Chart 1, bottom panel). A Political Showdown Is Looming One could argue that Peruvian financial markets have hit a floor and that much of the bad news has already been priced. Another argument is that Castillo will not be able to pass sweeping socio-economic reforms because of strong opposition from congress. In our opinion, Peru has yet to reach peak political tensions, which may very well end with a bang. Given this heightened political uncertainty, investors should brace themselves for a rocky ride. We identify two main risks plaguing Peruvian politics. First, the unsustainable ideological divide within Castillo’s proposed cabinet between far-left militants and the pragmatic center-left. Second, the looming clash between a government that wants to upend the country’s socioeconomic system and a notoriously harsh congress keen on making the president’s job unbearable. Intra-Government Dichotomy The ideological divide in Castillo’s government is extreme. On one side is the Marxist-Leninist wing, headed by Free Peru’s party leader, Vladimir Cerrón, and prime minister candidate, Guido Bellido. On the other side is the left-to-center members, headed by Pedro Francke, the minister of finance candidate. The more extremist Marxist-Leninist camp constitutes the majority, while moderates are a minority. Critically, the Marxist-Leninist radicals will make few concessions to the moderate ministers, as the former believe they have a mandate from the people to upend the country’s socio-economic system. Nevertheless, the policies supported by the general public are more nuanced than that. According to a national Ipsos survey from August, 85% of respondents believe president Castillo should govern with technocrats in his governments’ key positions. Only 11% support him making the ideology of his party the centerpiece of his policies and promoting (radical) members of his party. This shows how Castillo’s victory was more of a national referendum against Fujimori and the corrupt political elites than support for a radical socialist government. We elaborated on this topic in our previous report on Peru. The wide ideological divide between the party and a few moderate members of the cabinet in key positions will make governing extremely difficult. Cracks are already beginning to form. Bellido and Francke hold different views on the role of the state in the economy. Bellido, on the one hand, has stated he supports state-owned companies in commodity-extracting sectors (particularly natural gas and hydroelectricity) and the drafting of a new constitution to give the state greater ownership of mining contracts. Francke, on the other hand, wants to reinstate fiscal spending caps and is less harsh with multinational companies, favoring an increase only in mining taxes. Furthermore, there is significant uncertainty around the government’s official fiscal plan, as Francke has avoided giving clear figures on fiscal expenditures and social programs. To make matters worse, there is growing concern that it is party leader Cerrón who is de facto in charge, and that he has an enormous influence on Castillo. Cerrón is unpopular among voters as a result of his criminal allegations, close ties to the Cuban regime, and often apologetic stance toward the Maoist terrorist group, Shining Path. Although he intended to run as the presidential candidate for Free Peru, he was banned from the election because of ongoing criminal accusations, which is why he handpicked Castillo as his replacement. Without a doubt, he intends to be heavily involved in government decision-making. According to the same Ipsos poll we cited earlier, 61% of Peruvians believe Cerrón is either de facto in charge of the government or holds considerable sway over Castillo. The biggest risk to financial markets will be the eventual dismissal or resignation of finance minister Francke. This may happen as he eventually realizes that the radicals will concede very little. This would also lead to a resignation of orthodox central bank governor Julio Velarde, who Francke has been able to convince to remain in his post. These two resignations would result in another riot in Peruvian markets, as the investment and business communities fully lose confidence in Castillo’s government.  An Inevitable Clash Between The Government And Congress Being president in Peru is a notoriously difficult job due to the large sway that congress has on legislation and governing. The outcome of this constant confrontation between the president and congress has been five different presidents in the past five years alone. Critically, this tension has never been higher. The government and congress hold diametrically opposed views on the broad vision and strategy for the nation and how the economy should be managed. On the one hand, congress is mainly composed of traditional centrist parties and the opposition holds a majority—Castillo’s coalition has only about 39% of the seats. On the other hand, the government has just been elected on a far-left reformist platform. In essence, both the government and congress have incentives and the determination to be as obstructive as possible for each other. As tensions ramp up and confrontation becomes inevitable, the risks of unrest and clashes between supporters of Castillo and congress will rise. Table 1Peru: Voters Support More Moderate Politicians Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point In congress’s point of view, they have a mandate to serve as an opposing force to Castillo’s radicalism: There is some validity to this claim. The opposition holds a majority, and congress president Maricarmen Alva is by far more popular than the leaders of the Free Peru party like Cerrón and Bellido (Table 1). Given that Castillo’s ideology is a threat to the nation’s current socio-economic model and, thereby, to the political establishment, the majority in congress would prefer to block all radical legislation, including the appointments of controversial cabinet members. In addition, they will use all manner of accusations and alleged linkages between cabinet members and Shining Path to impeach Castillo. Congress needs only 87 votes, which means they need to convince only eight members from the governing alliance to impeach Castillo. In turn, the government argues it was elected to upend the country’s status quo and confront the unpopular political elites: Critically, the president has the ability to dissolve congress after two votes of no confidence, thereby putting pressure on congress to abide by the government’s radical proposals. This latter point and the fact that congress has little popular support provide leverage for the government over congress. Given the fact that current congressional members cannot be reelected, they might be more careful about how they maneuver, so that they do not provoke Castillo to dissolve congress. There are, therefore, two extreme possible outcomes. On one hand, congress may impeach the president, triggering a social revolt from Castillo’s hardline supporters against congress. On the other hand, congressional members may allow the passing of a leftist legislative agenda in order to maintain their seats, which would gravely reduce corporate profitability and productivity in Peru. Both scenarios would result in a collapse of investor and business confidence, leading to more capital flight and a riot in Peruvian financial markets. Bottom Line: Political volatility in Peru has not yet reached its apex. Clashes between the government and congress are inevitable, as well as among key cabinet members. Such elevated political volatility warrants a higher risk premium on Peruvian assets. Return Of Macro Instability Peru enjoyed a period of relative macro stability from the early 2000s until recently. Its currency, local interest rates, and sovereign spreads have fluctuated less than those in other Latin American countries. However, the nation’s economy and financial markets have entered a period of heightened volatility. Both domestic and external macro factors have turned into headwinds for the Peruvian economy and financial markets. Chart 2Peru: Business Confidence Will Continue Plummeting Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Domestically, the economic recovery has been uninspiring, and multiple indicators point to growth disappointments ahead: Business confidence took another serious hit with the election of Castillo and ensuing uncertainty (Chart 2). Imminent political volatility will further depress business confidence, and, consequently, capital expenditures and hiring in the coming months. This will curb household income growth and consumer spending. Peru remains one of the world’s deadliest COVID-19 hotspots (Chart 3, top panel). In addition, vaccination rates are the lowest among major Latin American economies (Chart 3, bottom panel). As the more infectious Delta variant becomes dominant, there will not be enough immunity to hold back new cases. Consequently, either the government will introduce lockdowns or people will voluntarily limit their activities, thereby inhibiting the nascent economic recovery. The unemployment rate remains far above its pre-pandemic level (Chart 4). Thus, household income remains very depressed. The latter does not bode well for debtors’ ability to service debt. Chart 3Peru: The Government Has Grossly Mismanaged The Pandemic Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Chart 4Peru: Labor Market Has Not Fully Recovered Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point   As a result, loan delinquencies will rise anew, weighing on banks’ appetite to lend. Notably, local currency loans to the private sector will contract (Chart 5).    Chart 5Peru: Prepare For A Credit Slump Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Commercial banking profitability is also vulnerable, as president Castillo aims to strengthen the state bank (Banco de la Nación) by expanding its operations and undercutting private banking fees. Given financials of the bourse’s market cap, poor banking profitability is a major risk to this stock market. Unrelenting currency depreciation—see below for a more detailed analysis of the exchange rate—will prompt the central bank to hike rates further. This will not only weigh on new credit demand, but also augment loan delinquencies in the banking system. As a result, banks will become very risk averse and shrink their balance sheets. A credit crunch will ensue. Even though fiscal spending will be increased, it is unlikely to propel economic growth. The basis is that fiscal primary spending accounted for less than 15% of GDP before the pandemic and is now 17% due to the pandemic distortion (Chart 6). In the meantime, consumer spending constitutes 63% of GDP, capital spending 21%, and exports 25%. Externally, deteriorating balance of payments dynamics will weigh down on the currency: Peruvian assets tend to move with the country’s trade balance and global metal prices. The fact that Peruvian stock prices have plummeted in the face of rising industrial and precious metal prices supports a bearish thesis on this bourse (Chart 7). Chart 6Peru: Fiscal Expenditures Have Risen Due To The Pandemic Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Chart 7Rising Metal Prices Have Failed To Boost Peruvian Stocks Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Chart 8China's Slowdown Portends A Fall In Commodities Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Export revenue will contract as a result of a decline in commodity prices brought on by China’s slowing “old economy” (Chart 8). Precious and industrial metals together account for 66% of Peru’s merchandise exports. A meaningful decline in metal prices will erode the trade surplus and weigh on the exchange rate. Furthermore, Peru is already experiencing capital flight. Potential anti-market policies from this government could trigger more capital exodus. The capital account deficit will widen as both FDI and portfolio inflows fall due to the negative commodity outlook as well as political uncertainty (Chart 9). Foreigners still hold 45% of local currency bonds, and they will reduce their holdings (Chart 10). Chart 9Peru: FDI Inflows Will Decline Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Chart 10Peruvian Domestic Bonds: Will Banks Make Up For Foreign Investor Retrenchment? Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Chart 11Peru: The Dollarization Rate Has Room To Rise Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point Currency depreciation will also be reinforced by locals converting their sol deposits into foreign currency. The dollarization rate—the ratio of foreign currency banking deposits to total deposits—will rise (Chart 11). A weakening currency will also lead to higher inflation expectations, to which the central bank will respond by raising rates. The monetary authorities already hiked the policy rate by 25 basis points this month due to higher-than-expected inflation and a rapidly depreciating currency. As Peru’s exchange rate continues to weaken, the central bank might also sell foreign currency reserves to prevent large fluctuations in the value of the currency. This foreign exchange intervention will, in turn, shrink banking system local currency liquidity and lift interbank rates (Chart 12). Chart 12FX Reserve Sales Will Shrink Banking Liquidity And Lift Interbank Rates Peru: Approaching A Boiling Point Peru: Approaching A Boiling Point In short, the central bank has enough international reserves to stabilize the exchange rate, but this will come at the cost of tighter liquidity and higher interest rates. The latter will only reinforce sluggish growth in domestic demand. Bottom Line: Heightened political volatility and lower metal prices are working against the Peruvian economy and its financial markets. Peru is experiencing large capital flight, which will exacerbate currency depreciation. Investment Recommendations Keep an underweight allocation to the Peruvian bourse within an EM equity portfolio. We recommend currency traders go short the Peruvian sol versus the US dollar. While the sol has already depreciated considerably, the domestic and external headwinds entail more downside. For fixed-income investors, we maintain an underweight allocation to Peruvian sovereign credit in an EM credit portfolio. The basis for this position is that the nation’s fiscal policy may undergo a major shift, entailing larger fiscal spending and wider budget deficits. We are downgrading local bonds from neutral to underweight in an EM domestic bond portfolio. Critically, the share of foreign ownership of Peruvian local fixed income remains one of the highest in the EM universe—it has only fallen from around 55% to 45% of domestic fixed-income instruments in the past six months (Chart 10 on page 9). Thus, there is a major risk that foreign investors will sell domestic bonds as the currency depreciates further, which will weigh down on local bonds. Juan Egaña Research Analyst juane@bcaresearch.com Footnotes

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas China Spreads The Wealth Around China Spreads The Wealth Around Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 China Spreads The Wealth Around China Spreads The Wealth Around Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade China Spreads The Wealth Around China Spreads The Wealth Around While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan China Spreads The Wealth Around China Spreads The Wealth Around Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) China Spreads The Wealth Around China Spreads The Wealth Around Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights The baht will depreciate further, given the state of the economy and external accounts. Domestic demand was already relapsing, even before the latest surge in COVID-19 cases. Now, the recovery will be delayed more. The authorities have little to offer by way of fiscal or monetary support. Credit to the job-intensive SME sector has collapsed. The balance of payment dynamics remains negative for the currency. Investors should stay short the baht. Dedicated EM asset allocators should continue to be neutral on Thailand within respective equity and domestic bond portfolios. Feature Chart 1Thai Stocks Are Facing Several Headwinds Thailand: Stay Short The Baht Thailand: Stay Short The Baht Our negative view on the baht has played out as expected.1 The Thai currency is down 10% versus the dollar since its peak in February of this year. It has also been the worst performer in Asia. The country’s stock market is struggling and going down in both absolute terms and relative to their EM counterparts (Chart 1). Going forward, odds are that the baht will remain weak. A weak currency will continue to stifle both Thai stocks’ and local currency bonds’ relative performance. Investors should stay short the baht and remain neutral Thai equity and local currency bonds within their respective EM portfolios. Relapsing Growth Chart 2Surging New COVID-19 Cases... Thailand: Stay Short The Baht Thailand: Stay Short The Baht The latest spike in new COVID-19 cases has dashed hopes for any early recovery of the Thai economy (Chart 2). Earlier this month, the central bank revised down their GDP forecast for 2021 from 1.8% to 0.7%. We concur with this bearish outlook: Private consumption in real terms was languishing as of June this year at 10% below 2019 levels. Car sales, both personal and commercial, are even more downbeat (Chart 3). After the latest surge in new COVID-19 cases, those numbers must have weakened further. Incidentally, the country’s vaccination rate, at 26% of total population (7.5% fully vaccinated), remains low. It could be, therefore, several months before any meaningful recovery in consumer demand takes place. Faced with low demand, the country’s manufacturing and shipment volumes are also weak. They are both breaking down anew from well below the 2019 levels (Chart 4, top panel). Chart 3...Will Further Delay Domestic Demand Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 4Manufacturers Are Saddled With High Inventory Amid Weak Orders... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Weak demand also means that businesses are stuck with high inventories. Indeed, there is a widening disparity between inventory levels and shipments (Chart 4, middle panel). Furthermore, order books have slipped back to levels not seen since the height of the COVID-19 scare early last year. The combination of high inventories and tumbling orders does not portend a manufacturing recovery anytime soon (Chart 4, bottom panel). Notably, jobs and wages are also weak. Employment in the manufacturing sector is well below pre-pandemic levels (Chart 5). This trend, in turn, is hurting household income and consumer demand, completing a vicious cycle of depressed demand, weak production, falling employment and household income, and further reduced demand. The softness of the economy is accentuating the disinflationary pressure that was already entrenched. Headline and core CPI in Thailand have stayed mostly below 1% over the past five years — the lower band of the central bank’s inflation target. Now, they are flirting with outright deflation. In fact, if the impact of food and oil prices is excluded, the prices are actually deflating (Chart 6). Chart 5...Which Is Hurting Jobs And Wage Growth Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 6Thailand Is Flirting With Outright Deflation... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Outright deflation makes it harder for borrowers to service their debts, which then discourages both borrowing and spending — making the recovery much harder. Notably, the banks’ prime lending rates remain high at 5.4%, which means real prime lending rates are quite steep at 5% (deflated by core CPI). This is at a time of very low household income and business revenue growth expectations. This trend is a strong disincentive for borrowing and consuming /capital spending. Little Policy Support What is more concerning for the economy is that policymakers can offer little to boost the economy. Fiscal stimulus has waned: government expenditure, after a surge last year, is now contracting (Chart 7). The budget proposal for the next fiscal year (October 2021 - September 2022) that was passed by the parliament in June 2021 (first reading)2 stipulates a 5.7% cut in nominal spending. Part of the reason is that fiscal deficits have already ballooned to a staggering 8% of GDP — from an average of 2.5% in the past ten years. The IMF estimates that the fiscal thrust will be zero this year, and a negative 2.4% of GDP in 2022 (Chart 7, bottom panel). The monetary policy transmission is also paralyzed. Despite easing by the Bank of Thailand — the policy rate is at an all-time low of 0.5% since May last year — credit growth is dismal. Lenders are wary of rising NPLs and are holding back new credit: The share of impaired loans (NPLs plus Special Mention Loans) of total bank loans has dramatically increased to 10%. In the case of small and medium enterprises (SMEs), that ratio is 20%. By comparison, loss provisions are much lower, at just 5.2% as of June of this year (Chart 8, top panel). Chart 7...Yet, The Government Is Planning To Cut Fiscal Spending Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 8Sharp Rise In Banks' Stressed Loans Amid Tanking Profits... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Notably, both operating and net profits of banks had already halved (as a % of assets) by June 2021 — as both interest and non-interest incomes dropped. Profits are slated to contract further, since banks will have to make greater provisions in the future as the recent surge in new cases will produce more loan delinquencies (Chart 8, bottom panel). The specter of rising NPLs has prompted banks to retrench loans. In particular, bank credit to SMEs has plunged by a massive 34% from 2019 levels (Chart 9). Before the pandemic, banks’ SME loans made up a significant 30% of GDP. Now, they are down to 21%. Credit retrenchment of this order to the job-intensive SME sector is going to have a significant negative ripple effect. Employment will shrink further as small businesses go bust. Shrinking jobs will dent household income, and, in turn, consumer demand. Incidentally, loans to other business segments are also not rising much. Bank loans to all non-financial corporates are growing rather minimally, at 1.5% year-over-year. Going into the pandemic, the Thai household sector was already highly leveraged. Over the past two decades, banks and other financial institutions have been lending ever more to households, shunning non-financial corporates. Households’ borrowing from banks have now risen to 40% of GDP; and those from other institutions another 50%. These loans had helped boost consumer demand all those years, but now, at a time when incomes are uncertain, households have very limited appetite to borrow more to spend. This means a consumer debt-fueled demand recovery is not in the cards (Chart 10). Chart 9...Induced Banks To Massively Reduce Credit To The Job-Intensive SME Sector Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 10Thai Households Are Too Indebted To Borrow More And Spend Thailand: Stay Short The Baht Thailand: Stay Short The Baht   In brief, Thai businesses are in the middle of a toxic combination of contracting sales, absent fiscal support, slashed credit facilities, and rather high borrowing costs in real terms. Chart 11 shows that corporate profit margins of non-financial firms are struggling at a low level. It is no wonder that businesses are reluctant to invest, expand, and hire. The message is similar when we examined all companies included in the MSCI Thailand stock index. On the one hand, their EPS has fallen to 10-year lows. Thai stock prices, on the other hand, have not yet fallen as much as the shrinking EPS would imply (Chart 12, top panel). The consequence is that the valuations are remarkably stretched—near a 20-year high (Chart 12, bottom panel). Chart 11Low Margins Are Discouraging Thai Firms To Borrow, Invest, Or Hire Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 12Thai Profits, At A Decade-Low, Are Also A Headwind For Stock Prices Thailand: Stay Short The Baht Thailand: Stay Short The Baht   All in all, for Thai share prices to stage a sustainable rally, an economic recovery is essential. The first indications of that usually come from an improving order book. The latter currently shows little glimmer of hope. But investors should keep an eye on this indicator, as Thai stocks’ performance is geared to the ebbs and flows of the business order book (Chart 13). Thailand Needs A Weaker Currency The state of the Thai economy not only warrants exchange rate depreciation, but also needs a much weaker currency to help an economic recovery. The country’s balance of payment is in deficit — for the first time since 2014. A crucial reason is that the baht is still expensive, which continues to weigh on exports. Of all the export-oriented Asian economies, Thai exports recovery has been the weakest (Chart 14). Chart 13Keep An Eye On The Order Book For A Sign In Stock Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 14An Expensive Baht Held Back Thai Exports Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht   The fact that a quarter of Thai exports go to other ASEAN countries — where demand has been and remains weak due to the lingering pandemic — doesn’t help either. As a result, the Thai trade surplus has narrowed significantly, and the current account has slipped into deficit (Chart 15, top and middle panels). The other main external revenue source of Thailand, tourism, continues to be near absent at 0.6% of GDP — a far cry from a high of 12% before the pandemic (Chart 15, bottom panel). What’s more, there is little hope of any recovery in the near future. The government now expects the number of foreign tourists this year to be as low as 0.3 million versus 40 million in 2019. On the capital account front, Thailand continues to hemorrhage both FDI and portfolio capital — just as it did the past several years. Despite that, the baht had remained strong until early this year, as a result of a substantial repatriation of bank deposits by Thai residents and, to a lesser extent, foreign borrowings. Those inflows prevented the Thai baht from depreciating. But such panic-stricken, one-off savings/deposit repatriations by Thai residents will certainly slow materially going forward (Chart 16). Chart 15The Thai Current Account Balance Will Struggle To Stay In Surplus... Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 16...While The Capital Account Balance Will Slip Deeper Into Deficit... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   There’s also little hope that FDI and portfolio inflows will pick up the slack. The reason is that the Thai economy is very weak and the return on capital is low. The latter discourages capital inflows. The fact that the baht continues to be an expensive currency in real terms, and therefore not as competitive as some of its neighbors’, doesn’t help either. The multi-nationals who are planning to re-locate out of China might find some other countries — where the currency is more competitive (such as in India, Malaysia, or the Philippines) — more attractive. Overall, the Thai capital account balance will likely slide deeper into deficit, at a time when the current account will also struggle to stay in surplus. The result will be a further deterioration in the country’s balance of payment, hurting the baht (Chart 17). Considered from another angle, if the return on capital on Thai assets is any guide, the baht could drop much more from its current levels (Chart 18). Chart 17...Putting Downward Pressure On The Baht Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 18Thai Firms' Low Rates Of Return Point To More Baht Depreciation Thailand: Stay Short The Baht Thailand: Stay Short The Baht     The reality is that, given Thailand’s current macro backdrop, a cheaper currency is what the nation needs. That will help boost growth significantly by aiding exports and promoting import substitution. Since foreign trade makes up an impressive 90% of GDP, a boost therein could kickstart the entire economy. Another result of a weaker currency will be higher inflation, something the economy seriously needs. Higher inflation will contribute to lower real interest rates which, in turn, will encourage borrowing and spending. Higher spending and inflation will help achieve higher nominal sales, boost firms’ profits, employment, and eventually, household incomes. All in all, it could allow a productive cycle to unfold. Given all these possible benefits and given that policymakers have few other tools at their disposal at this juncture, chances are the central bank will let the baht depreciate more, albeit in an orderly fashion, in the months to come. What About Bonds? Chart 19Mantain A Neutral Allocation To Thai Domestic Bonds In An EM Basket Thailand: Stay Short The Baht Thailand: Stay Short The Baht Thai local currency bonds’ absolute return in US dollar terms, as expected, is highly dependent on the exchange rate (Chart 19, top panel). Given the weak currency outlook, foreign investors should refrain from holding Thai domestic bonds outright. For foreign asset allocators, however, the matter is more nuanced. Thai domestic bonds’ relative return versus that of overall EM did not depend on the baht movement alone. This is because Thailand has been a defensive market owing to the following: a traditionally strong current account, a manageable public debt (now 47% of GDP), and a relatively low holding of bonds by foreign investors (now 12% of total). A robust current account surplus for years meant that during periods of negative growth shocks, the baht often fell less than many other EM currencies — that is, in periods of distress, the baht helped boost the relative performance of Thai bonds vis-à-vis overall EM bonds in US dollar terms. Those periods of distress also saw Thai bond yields fall as the central bank was able to cut rates due to low inflation. In addition, during those periods, local investors moved from equities to government bonds. Since the holdings of local bond investors far outweighed those of foreign investors, Thai bond yields managed to go down, even when some foreign investors dumped EM and Thai domestic bonds. As a result of these factors, Thai bonds outperformed their EM counterparts during the commodity/EM slowdown in 2014-15, and again at the height of the COVID-19-scare in early 2020 — even though the baht fell versus the US dollar during those periods (Chart 19, middle panel). All that said, the reality in the ground has changed somewhat since early last year. The Thai current account is no longer in surplus, and, given the dismal tourism outlook and slowing trade surplus, it will probably stay that way for the foreseeable future. That will keep the baht relatively weak weighing on Thai bonds’ relative performance versus their EM peers. On the other hand, the grim outlook of the Thai economy and looming deflation risk means that Thai bond yields could fall going forward relative to their EM counterparts. That will be a tailwind for Thai domestic bonds’ relative outperformance versus their EM counterparts. There is, therefore, a good chance that the headwind from a relatively weaker baht could be somewhat compensated for by a drop in Thai local yields versus their EM peers. Indeed, the periods of the baht’s weakness usually coincided with Thai bonds’ relative yield compression (Chart 19, bottom panel). This calls for a neutral outlook for relative bond performance going forward. Investment Conclusions Currency: The baht outlook remains precarious. Investors would do well to remain short the baht versus the US dollar. Domestic Bonds: Thai bond yields will go down. The Bank of Thailand will have no choice but to cut rates further. Local investors should stay long bonds. For international dedicated EM fixed-income portfolios, we downgraded Thai bonds in February of this year, from overweight to neutral in an EM bond portfolio, in view of the impending baht weakness. That turned out to be a good decision. Going forward, investors should continue to have a neutral allocation on Thai bonds, as the headwind from the baht will be mitigated by the tailwind from relative bond yield compression. Foreign absolute-return investors, however, should avoid Thai bonds in view of expected currency depreciation. Chart 20A Vulnerable Baht Will Keep Foreign Equity Investors Away Thailand: Stay Short The Baht Thailand: Stay Short The Baht Stocks: A struggling economy offers little hope for corporate margins or profits recovery soon. A vulnerable currency makes Thai stocks even less appealing to foreign investors. Without their participation, it will be hard for this market to rise sustainably in absolute terms or outperform their EM counterparts (Chart 20). Thai equities are not cheap either: the P/Book ratio is at par with EM. That said, given the Thai market’s already very steep underperformance versus the EM equity benchmark, from a portfolio strategy point of view, we recommend investors stay neutral this market within an EM equity portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to the EMS report “Thailand: Beset By A Vulnerable Baht,” dated February 24, 2021. 2 The budget bill has to pass the second and third readings expected in August before it goes for senate and royal approval.