Currencies

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear clients, This week we are sending you a Research Note on balance of payments across the G10, authored by my colleague Kelly Zhong. With unprecedented monetary and fiscal stimulus, balance-of-payment dynamics will become an even more important driver of currencies over the next few years. That said, while the US current account is in deficit, the short dollar narrative is beginning to capture investor imagination, suggesting the call is rapidly becoming consensus. We are in the consensus camp, but are going short GBP today, as a bet on a short-term reversal. As for cable, the recent rally has gotten ahead of potential volatility in the coming months, even though it is cheap. Finally, we are lowering our target on the short gold/silver trade to 65, but tightening the stop-loss to 75. I hope you find the report insightful. Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights COVID-19 has turned the world upside down this year, and severely impaired global trade. Global trade values plunged by 5% quarter-on-quarter in the first quarter, and are forecasted to have slumped by 27% in the second quarter. Most countries have also seen negative foreign direct investment (FDI) growth in the first few months of 2020. Global FDI inflows are forecasted to fall by 40% this year and drop by an additional 5-10% next. While all countries have been hit by COVID-19, the economic damage appears particularly pronounced in countries heavily reliant on foreign funding. Feature COVID-19 has turned the world upside down in 2020. The global economy headed into recession following a decade-long expansion. While many economies are starting to ease restriction measures, the possibility of a second wave remains a big downside risk to the global economy. If history is any guide, the Spanish flu during the early 1900s came in three waves, the second of which brought the most severe damage. Undoubtedly, international trade has been under severe pressure this year. Global trade volumes plunged by 5% in the first quarter, and are expected to be down 27% in the second quarter from their levels in the final three months of 2019. Moreover, the path of recovery remains uncertain as the pandemic continues to disrupt global supply chains and weaken consumer confidence. According to the United Nations Conference on Trade and Development (UNCTAD), it may take until late 2021/early 2022 for global trade to recover to pre-pandemic levels (Chart 1). As reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19.  Global FDI inflows rebounded in 2019, reaching a total of $1.5 trillion, as the effect of the 2017 US tax reforms waned and US repatriation declined. This year, however, most countries have seen negative FDI growth rates in the first few months in 2020. According to UNCTAD, global FDI inflows are forecast to plunge by 40%, bringing total FDI inflows below the US$1 trillion level for the first time since 2005 (Chart 2). Unfortunately, as reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19. Typically, FDI flows bottom only six to 18 months after the end of a recession. FDI inflows are forecast to decline further by another 5-10% in 2021. Chart 1Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Chart 2Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 While all economies have been hit by COVID-19, the impact varies by region. Emerging market countries, particularly those linked to commodities and manufacturing-intensive industries, appear to be have been hit harder by the crisis. This makes sense, given trade is much more volatile than services or consumption. Chart 3 shows that while exports make up less than 30% of GDP in the US, they amount to over 130% of GDP in Thailand and Malaysia, and over 300% of GDP in Singapore and Hong Kong. Chart 3Reliance On Trade Differ Across Countries Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 Going forward, the recoveries might be uneven as well. Prior to COVID-19, global trade flows were already facing many challenges, including trade disputes, geopolitical tensions and rising protectionism. COVID-19 may have just supercharged two megatrends: Technology and Innovation: The pool of investments concentrated on exploiting raw materials and cheap labor is shrinking, while those promoting technology and ESG are becoming crucial. De-globalization: Policymakers in many countries are promoting more regulation and intervention, especially in key industries related to national security and health care. This suggests COVID-19 might represent a tipping point, making balance of payments all the more important for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. The euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses.  In this report, we look at the balance-of-payment dynamics in the G10. The most important measure for us is the basic balance, which takes the sum of the current account and net long-term capital inflows. Our rationale is that these tend to measure the underlying competitiveness of a currency more accurately than other balance of payment measures. On this basis, the euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses. The US is the worst (Chart 4). Below, we visit some of key drivers behind these trends. Chart 4Basic Balances Across G10 Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 United States Chart 5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US basic balance is deteriorating again (Chart 5). The key driver has been a decline in foreign direct investment. If this trend continues, this could further undermine the US currency. The US remains the world’s largest FDI recipient, attracting US$261 billion in 2019, which is almost double the size of FDI inflows into the second largest FDI recipient – China – with US$141 billion of inflows last year. However, cross-border flows have since fallen off a cliff after the waning effect of the one-time tax dividend introduced at the end of 2017. The lack of mega-M&A deals has also been a contributing factor. The trends in the trade balance have been flat, despite a push by the Trump Administration to reduce the US trade deficit and rejuvenate the US economy. The most recent second-quarter data show a deterioration from -2.3% of GDP to -2.8%. The trade deficit with China did drop by 21% to $345 billion in 2019, however, US companies quickly found alternatives from countries that are not affected by newly imposed tariffs, particularly from Southeast Asia: The US trade deficit with Vietnam jumped by 30%, or $16.3 billion, in 2019. More recently, exports have plunged much faster than imports, further widening the US trade deficit. On portfolio flows, the most recent TIC data show that US Treasurys continued to be shunned by foreigners in May. In short, the US balance-of-payment dynamics are consistent with our bearish dollar view. Euro Area Chart 6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Of course, an apex in globalization will hurt this thesis, but the starting point for the euro area is much better than many of its trading partners. The trade surplus in the euro area was not spared from COVID-19 – it plunged to €9.4 billion in May from €20.7 billion the same month last year, as the pandemic hit global demand and disrupted supply chains. Exports tumbled by 29.5% year-on-year to €143.3 billion while imports declined by 26.7% to €133.9 billion. Even in this dire scenario, the trade surplus still remains a “healthy” 1.8% of GDP, buffeting the current account (Chart 6). Foreign direct investment inflows have regained some ground in recent years, with the improvement accelerating in recent months. FDI inflows surged by 18% in 2019, reaching US$429 billion. Outflows also rose by 13% in 2019, led by a large increase in investment by multinationals based in the Netherlands and Germany. Going forward, FDI is sure to drop, but this will not be a European-centric problem. Portfolio flows have started to reverse, but have not been the key driver of the basic balance. This is because ever since the European Central Bank introduced negative interest rates in 2014, portfolio outflows have been persisted. This also makes sense since Europeans need to recycle their excess savings abroad. In sum, despite the headwinds to global trade and investment, the basic balance remains at a healthy 2.9% of GDP, which bodes well for the euro. Japan Chart 7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments A key pillar for the basic balance in Japan has been the current account balance, which has been buffeted over the years by income receipts from Japan’s large investment positions abroad. Going forward, this could make the yen very attractive in a world less reliant on global trade. Japanese exports tumbled by 26.2% year-on-year in June, led by lower sales in transport equipment, motor vehicles and manufactured goods. However, the slowing export trend was well in place before the pandemic. Exports had been declining for 18 consecutive months before COVID-19 dealt the final blow. Imports also fell by 14% year-on-year in June, led by lower energy prices. On the service side of the income equation, foreign visitors to Japan dropped by 99.9% from over 2.5 million in January to less than 2,000 in May. That equates to about 2% of the Japanese population. Despite all this, Japan still sports a healthy current account surplus, at 4% of GDP (Chart 7). In 2019, Japan remained the largest investor in the world, heavily recycling its current account surplus. FDI outflows from Japanese multinationals surged by 58% to a record US$227 billion, including US$104 billion in cross-border M&A deals. Notable mentions include Takeda acquiring Shire (Ireland) for US$60 billion, and SoftBank Group acquiring a stake in WeWork (the US) for US$6 billion. In terms of portfolio investments, foreign bond purchases have eased of late as global interest rates approach zero. Higher real rates are now being found in safe-haven currencies like the Swiss franc and the Japanese yen, which is supportive for the yen. Overall, the basic balance in Japan is at nil, in perfect balance between domestic savings and external investments. United Kingdom Chart 8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The key development in the UK’s balance-of-payment dynamics is that a cheap pound combined with the pandemic appear to have stemmed the decline in the trade balance. The UK has run a current account deficit each year since 1983. This has kept the basic balance mostly negative (Chart 8). That could change if the marginal improvement in trade is durable and meaningful. The current account deficit further widened to £21.1 billion, or 3.8% of GDP, in the first quarter, of which the goods trade balance was more volatile than usual. Since May, the goods trade balance has been slowly recovering to £2.8 billion, but has been offset by the services trade deficit. The primary income deficit also widened in the first quarter as offshore businesses rushed to preserve cash buffers. Foreign direct investment in the UK has been improving of late, currently sitting at 3.7% of GDP. This is encouraging, given the steep post-Brexit drop. Going forward, we continue to favor the British pound over the long term due to its cheap valuation. However, we are going short today, as a play on a tactical dollar bounce. More on this next week.       Canada Chart 9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments The Canadian basic balance has been flat for over a decade, as the persistent current account deficit has continuously been financed by FDI inflows and portfolio investment (Chart 9). This is a vote of confidence by investors over longer-term returns on Canadian assets. Canada is one of the largest exporters of crude oil, meaning the fall in resource prices generated a big dent in export incomes. However, the country is slowly on a recovery path. Exports increased 6.7% month-on-month in May, helping narrow the trade deficit to C$0.7 billion. More importantly, a positive net international investment position means that positive income flows into Canada are buffeting the current account balance. In 2019, Canada was the 10th largest FDI recipient in the world, with FDI inflows increasing to US$50 billion. Today, the basic balance stands at a surplus of 1% of GDP.               Australia Chart 10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia’s trade balance has been rapidly improving since the 2016 bottom, and has been the primary driver of an improving basic balance. While exports fell as the pandemic hit a nadir, imports fell more deeply. This allowed the trade surplus to widen in the first six months of the year compared to last year. Australia has long had a current account deficit, as import requirements to help drive investment opportunities were not met by domestic savings. With those projects now bearing fruit, the funding requirement has greatly eased. This has buffeted the current account balance, which turned positive for the first time last year following a 35-year-long deficit, and continues to rocket higher (Chart 10). Going forward, Australia’s trade balance and current account balance are likely to continue increasing as Australia has a comparative advantage in exports of resources, especially LNG, which is consistent with the ESG megatrend. Australia is also introducing major reforms to its foreign investment framework to protect national interests and local assets from acquisitions. Meanwhile, net portfolio investment remains negative, suggesting the current account surplus is being recycled abroad. In short, we believe the Aussie dollar has a large amount of running room, based on its healthy basic balance surplus of 4% of GDP. New Zealand Chart 11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments Compared to its antipodean neighbour, the New Zealand basic balance has been flat for many years, but has seen recent improvement (Chart 11). The trade balance was boosted by goods exports, which were up NZ$261 million, while imports were down NZ$352 million in the first quarter of this year. The rise in goods exports was led by an increase in fruit (mainly kiwifruit), milk, powder, butter and cheese. More recently, due to the ease of lockdown measures, exports increased by 2.2% year-on-year in June while imports marginally rose by 0.2%, further enhancing New Zealand’s trade balance. The primary income deficit widened to NZ$2.2 billion in the first quarter due to less earnings on foreign investment. Moreover, the secondary income deficit also widened, driven by a smaller inflow of non-resident withholding tax. Despite this, the current account deficit narrowed to NZ$1.6 billion in the first quarter, or 2% of GDP, the smallest deficit since 2016.  New Zealand received $5.4 billion in FDI flows in 2019, rising from only $2 billion in 2018. Most FDI inflows arrived from Canada, Australia, Hong Kong and Japan. Impressively, according to the World Bank’s 2020 Doing Business Report, New Zealand ranked first out of 190 countries due to its openness and business-friendly economy, low levels of corruption, good protection of property rights, political stability and favorable tax policies. Portfolio investment inflows also increased by NZ$11.8 billion.  The improvement in the backdrop of New Zealand’s basic balance will allow it to outperform the US dollar. As a tactical trade, however, we are short the kiwi versus the CAD. The basis is that relative terms of trade favor the CAD for now. Switzerland Chart 12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland’s basic balance is almost always in surplus, driven by a structural uptrend in the trade balance (Chart 12). This has allowed the trade-weighted Swiss franc to outperform on a structural basis. We expect this trend to continue. As a country consistently running high surpluses, Switzerland also tends to invest more in foreign assets. Over the years, these smart investments have helped buffet the current account. Overall, in the first three months of this year, the current account balance stood at CHF 17.4 billion, or 11.2% of GDP. In terms of the net international investment position, both stocks of assets and liabilities fell by CHF 110 billion and CHF 42 billion, respectively in the first quarter, due to falling equity prices globally. The net international investment position fell by CHF 67 billion to CHF 745 billion in the January-March period. That said, Switzerland continued to deploy capital abroad in the first quarter, which should help buffet the current account going forward. The positive balance-of-payment backdrop has created a headache for the Swiss National Bank. As such, the SNB will likely continue to intervene in the foreign exchange markets to calm appreciation in the franc. We believe the franc will continue to outperform the USD in the near term, but underperform the euro.  Norway Chart 13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway has a very open economy, with trade representing over 70% of GDP, and it has been hit quite hard by COVID-19 this year. The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown (Chart 13). More recently, Norway posted its first trade deficit in May since last September, which carried over to June, as exports fell more than imports. Thanks to increases in income receipts from abroad, the current account balance remained flat at NOK 66.1 billion in the first quarter. With persistent current account surpluses, Norway has long been a capital exporter. However, the FDI outflow and inflow gap is gradually closing. In 2019, net FDI was -3.5% of GDP. In the first quarter of this year, it was -3.3%. Portfolio outflows have also softened over the years, as the current account balance has narrowed. There was, however, a trend change in the first three months of this year - Norway’s purchases of foreign bonds, surged as investors switched to safer assets. Ultimately, we remain NOK bulls due to its cheap valuation. As economies gradually reopen and ease lockdown measures, the recovery in energy prices will push the Norwegian krone back toward its fair value.     Sweden Chart 14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments Sweden maintained its trade surplus with the rest of the world throughout the first few months of 2020 (Chart 14). Imports fell more than exports amid the pandemic. The goods trade balance almost doubled from the fourth quarter of 2019 to SEK 68.8 billion in the first quarter of 2020. The primary income surplus also increased by SEK 10 billion to SEK 42.2, further strengthening the current account and bringing the total current account surplus to SEK 80.6 billion, or 4% of GDP. Both FDI inflows and outflows have been increasing in Sweden, but the net number was slightly negative. In the first quarter of 2020, FDI inflows rose by SEK 51.6 billion while FDI outflows increased by SEK 100.6 billion. In terms of portfolio investment, Swedish investors reduced their portfolio investment abroad by SEK 141 billion in the first quarter, while foreigners decreased their portfolio investment in Sweden by SEK 45.8 billion. In conclusion, the Swedish krona remains one of our favorite longs due to its increasing basic balance surplus (4% of GDP) and its cheap valuation. We are long the Nordic basket (NOK and SEK) against both the euro and the US dollar. Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Please note that we will be on our summer holidays next week. Our next report will come out on August 20. Highlights The 30-year bond yield is the puppet master pulling the strings of all other investments. Where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. Continue to overweight 30-year bonds in the US and periphery Europe versus 30-year bonds in core Europe. Continue to overweight the US stock market versus the European stock market. An expected near-term setback to stocks versus bonds will briefly pause the European currency rally. The gold rally is also due a pause, given that it is overstretched relative to the decline in the real bond yield. Fractal trade: Long USD/PLN. Feature Chart I-1AThe Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... The Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... The Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... Chart I-1B...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare ...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare ...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare   The abiding mantra of this publication is that investment is complex, but it is not complicated. By complex, we mean that the financial markets are not fully predictable or analysable. By not complicated, we mean that the relative prices of everything are inextricably connected, rather like the movements of a puppet. All you need to do is find the puppet master pulling the strings. Right now, the puppet master is the 30-year bond. The Real Action Is In 30-Year Bonds While most people are focussing on the 10-year bond yield, the real action has been at the ultra-long 30-year maturity. In the US and periphery Europe, 30-year yields are within a whisker of all-time lows. Yet these ultra-long bond yields are still well above those in core Europe which are much closer to the lower bound. The upshot is that while all yields have equal scope to rise, yields have more scope to fall further in the US and periphery Europe than in core Europe (Chart I-2 and Chart I-3). Chart I-230-Year Yields In The US And Periphery Europe... 30-Year Yields In The US And Periphery Europe... 30-Year Yields In The US And Periphery Europe... Chart I-3...Are Still Well Above Those In ##br##Core Europe ...Are Still Well Above Those In Core Europe ...Are Still Well Above Those In Core Europe This simple asymmetry has created a winning relative value strategy that will keep on winning. Overweight 30-year bonds in the US and periphery Europe versus 30-year bonds in core Europe. Our preferred expression is to overweight 30-year bonds in the US and Spain versus Germany and France. Bond yields have more scope to fall further in the US and periphery Europe than in core Europe. Remarkably, in the US, the 10-year real yield is also tightly tracking the 30-year nominal yield (minus a constant 2.2 percent) (Chart I-4). Using a little algebra, this means that the market’s 10-year inflation expectation is just a steady-state value of 2.2 percent minus a shortfall equalling the shortfall in the 10-year nominal yield versus the 30-year nominal yield (Chart I-5). Chart I-4The 10-Year Real Yield Is Just ##br##Tracking The 30-Year Nominal ##br##Yield The 10-Year Real Yield Is Just Tracking The 30-Year Nominal Yield The 10-Year Real Yield Is Just Tracking The 30-Year Nominal Yield Chart I-5The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields 10-year inflation expectation = 2.2 – (30-year nominal yield – 10-year nominal yield) The reason that this is remarkable is we can explain the trend in inflation expectations from just the 30-year and 10-year nominal yields, and nothing more. In turn, gold is tightly tracking the inverted real yield, as it theoretically should. Gold, which generates no yield, becomes relatively more valuable as the real yield on other assets diminishes (Chart I-6). Having said that, the most recent surge in the gold price is stretched relative to its relationship with the real bond yield, suggesting that the strong rally in gold is due a pause (Chart I-7). Chart I-6Gold Is Just Tracking The (Inverted) Real Yield... Gold Is Just Tracking The (Inverted) Real Yield... Gold Is Just Tracking The (Inverted) Real Yield... Chart I-7...But Gold's Most Recent Surge Is ##br##Stretched ...But Gold's Most Recent Surge Is Stretched ...But Gold's Most Recent Surge Is Stretched The 30-Year Bond Is Driving Stock Markets Moving to the stock market, bank relative performance has closely tracked the collapse in the 30-year yield, because the collapsed bond yield signals both weaker bank credit growth and a likely increase in banks’ non-performing loans (Chart of the Week, left panel). Banks and other ‘value cyclicals’ whose cashflows are in terminal decline are highly sensitive to the prospects for near-term cashflows, which are under severe pressure in the pandemic era. At the same time, as the distant cashflows are small, the banks’ share prices are less sensitive to the uplifted net present values of these distant cashflows that come from lower bond yields. In contrast, technology, healthcare and other ‘growth defensives’ generate a growing stream of cashflows. Making their net present values highly sensitive to a change in the bond yield used to discount those large distant cashflows. The profits of the tech and healthcare sectors are proving to be highly resilient in the pandemic era. Through 2018, the 30-year yield went up by 1 percent, so the forward earnings yield of growth defensives went up by 1 percent (their valuations fell). Subsequently, the 30-year yield has collapsed by 2 percent, so unsurprisingly the forward earnings yield of growth defensives has also collapsed by 2 percent (their valuations have surged). To repeat, financial markets are not complicated (Chart of the Week, right panel). Moreover, the profits of the growth defensives are proving to be highly resilient in the pandemic era, holding up well in the worst shock to demand since the Great Depression. The combination of resilient profits with higher valuations explains why the technology and healthcare sectors are reaching new highs, while the rest of the stock market is going nowhere (Chart I-8). Chart I-8Tech And Healthcare At New Highs While The Rest Of The Market Languishes Tech And Healthcare At New Highs While The Rest Of The Market Languishes Tech And Healthcare At New Highs While The Rest Of The Market Languishes Meanwhile, the relative performance of stock markets is also uncomplicated. It just stems from the relative exposure to the high-flying growth defensive sectors. Compared with Europe, the US has a 20 percent larger exposure to technology and healthcare (Chart I-9). Which is all you need to explain the consistent outperformance of the US versus Europe (Chart I-10). Chart I-9The US Is 20 Percent Over-Exposed To Tech And Healthcare... The US Is 20 Percent Over-Exposed To Tech And Healthcare... The US Is 20 Percent Over-Exposed To Tech And Healthcare... Chart I-10...Which Explains Its Consistent Outperformance Versus Europe ...Which Explains Its Consistent Outperformance Versus Europe ...Which Explains Its Consistent Outperformance Versus Europe A Quick Comment On European Currencies And The Dollar Turning to the foreign exchange market, the recent rally in European currencies can at least partly be explained as a sell-off in the dollar. Begging the question, what is behind the dollar’s recent weakness? The dollar has moved as a mirror-image of the global stock market. For the broad dollar index, the explanation is quite straightforward. True to its traditional role as a haven currency, the dollar has moved as a mirror-image of the global stock market, measured by the MSCI All Country World Index (in local currencies). Simply put, as the stock market has shaken off its year-to-date losses, the dollar has shaken off its year-to-date gains (Chart I-11). Chart I-11The Dollar Has Just Tracked The (Inverted) Stock Market The Dollar Has Just Tracked The (Inverted) Stock Market The Dollar Has Just Tracked The (Inverted) Stock Market Looking ahead, we can link the prospects of currencies to the outlook for 30-year bond yields. A further compression in yields will weaken the dollar, and help European currencies, in two ways. First, as already mentioned, yields have more scope to decline in the US than in core Europe, and a fading US yield premium will weigh on the dollar. Second, to the extent that the lower yields can prevent a protracted bear market in stocks and other risk-assets, non-haven currencies can perform well versus the haven dollar.  Having said that, an expected near-term setback to stocks versus bonds will briefly pause the European currency rally. Concluding Remarks The charts in this report should leave you in no doubt that the 30-year bond yield – particularly in the US – is the puppet master pulling the strings of all investments: bond market relative performance, real bond yields, gold, banks, growth defensives, equity market relative performance, and major currencies. Which raises the crucial question, can the downtrend in 30-year bond yields continue? Yes, absent an imminent vaccine or treatment for Covid-19, the downtrend in yields can continue. As we explained last week in An Economy Without Mouths And Noses Will Lose 10 Percent Of Jobs, the spectre of mass unemployment is looming large. Specifically, the major threat to the jobs market lies in the coming months when government lifelines to employers – such as state-subsidised furlough schemes – are cut or weakened. Where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. Hence, it is inevitable that those central banks that can become more dovish will become more dovish. Given the political difficulties of using fiscal policy bullets, the lessons from Japan and Europe are that the monetary policy bullets get fully expended first. In practical terms, this means that where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. The upshot is that core European bonds will continue to underperform US bonds, and that the European stock market will continue to underperform the US stock market. European currencies will trend higher versus the dollar, albeit a setback to stocks versus bonds is a near-term risk to the European currency uptrend. Fractal Trading System* This week’s recommended trade is to play a potential countertrend move in the dollar via long USD/PLN. The profit target and symmetrical stop-loss is set at 4 percent. The rolling 1-year win ratio now stands at 57 percent. Chart I-12USD/PLN USD/PLN USD/PLN When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week A Massive Shock To Growth ... And Interest Rates A Massive Shock To Growth ... And Interest Rates Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Table 2Global Spread Products In Our Analysis Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns