Currencies

Highlights The bank credit 6-month impulse is likely to drop sharply in Europe, drop modestly in the US, but remain positive in China. Hence, the momentum of first-half economic data is likely to be worse in Europe than in China – albeit the Wuhan coronavirus scare is an unknown risk to this view. Initiate long CNY/GBP on a 6-month horizon. Underweight banks and the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. There will be a better time to enter these positions later in the year when 6-month impulses are improving. Long-term investors seeking value in Europe should focus on the main currencies and not on the main equity indexes. Fractal trade: long EUR/GBP. Europe And China Play A Role-Reversal In recent dispatches we have highlighted that the euro area bond yield 6-month impulse stands near +100 bps, posing the strongest headwind to growth for three years. To make matters worse, the impulse has flipped from a strong -100 bps tailwind last summer into the current strong headwind, equating to a marked deterioration in the weather. But in China, it is the opposite story. Last summer, the China bond yield 6-month impulse constituted a strong +80 bps headwind; today the headwind has disappeared. Indeed, it has morphed into a tailwind, albeit a very mild tailwind at just -10 bps. In this sense, Europe and China are now playing a role-reversal. The momentum of first-half economic data is likely to be worse in Europe than in China – albeit with the caveat that the Wuhan coronavirus scare is an unknown risk to this view (Chart of the Week). Chart of the WeekBond Yields In Europe And China Play A Role-Reversal Bond Yields In Europe And China Play A Role-Reversal Bond Yields In Europe And China Play A Role-Reversal For the sake of completeness, we should address the world’s other large economy, the United States. Just as in the euro area, the US bond yield 6-month impulse has flipped from a strong -100 bps tailwind last summer into a current headwind. But the headwind, at +50 bps, is not as strong as it is in the euro area (Chart I-2). Chart I-2Headwind Impulses In The Euro Area And The US, But Not In China Headwind Impulses In The Euro Area And The US, But Not In China Headwind Impulses In The Euro Area And The US, But Not In China The Four Impulse Framework For Short-Term Growth The bond yield 6-month impulse is the first component of our proprietary ‘four impulse framework’ for short-term growth. The bond yield 6-month impulse is important because it usually leads the framework’s second component, the bank credit 6-month impulse, by a few months. This relationship makes perfect sense as, at the margin, it is the price of credit that drives credit demand. Indeed, to the extent that monetary policy drives growth, this is the main mechanism by which it operates, albeit with a slight delay. The bond yield impulse usually leads the credit impulse. On this compelling theoretical and empirical evidence, the bank credit impulse is now likely to drop sharply in the euro area (Chart I-3), drop modestly in the US (Chart I-4), but remain positive in China (Chart I-5). Chart I-3The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... Chart I-4...Drop Modestly In ##br##The US... ...Drop Modestly In The US... ...Drop Modestly In The US...   Chart I-5...But Remain Positive In China ...But Remain Positive In China ...But Remain Positive In China But we must also consider the other two impulses in our four impulse framework. In the case of the euro area, the third important impulse is the oil price 6-month impulse. This is because the euro area relies on oil imports whose volumes tend to be price inelastic. Hence, when the oil price falls it subtracts from imports, thereby adding to net exports and growth – and vice-versa when the oil price rises. In the middle of 2019, the oil price impulse constituted a very strong headwind which helps to explain the midyear sharp slowdown in Germany. Subsequently, the headwind eased, even reversing into a modest tailwind which facilitated a recovery. But the tailwind is now fading (Chart I-6).  Chart I-6A Fading Tailwind From The Oil Price 6-Month Impulse A Fading Tailwind From The Oil Price 6-Month Impulse A Fading Tailwind From The Oil Price 6-Month Impulse The fourth and final component of our four impulse framework is geopolitical risk. This is not an impulse in the strict mathematical sense, but it is the same broad idea applied to the flow of geopolitical tail-events, both negative and positive. Europe’s positive events came several months ago: first in early-August when Italy ousted the firebrand Matteo Salvini from government; then in early-October when the UK parliament legislated against a no-deal Halloween Brexit. The tailwind from these positive events has now likely faded. For China, a positive geopolitical event and potential mild tailwind has come more recently, with the signing of the phase one trade deal with the US. Against this, the Wuhan coronavirus scare is a new risk – though based on the latest information it is unlikely to impact a 6-month view. The tailwind from the oil price impulse is now fading. On the four impulse framework, the momentum of first-half economic data is likely to favour China over Europe. We have found that the best way of playing this is through the exchange rate (Chart I-7), though given recent moves our preferred expression is versus the pound rather than the euro. Hence, on a 6-month horizon, initiate long CNY/GBP. Chart I-7Play Relative Impulses Through Currencies Play Relative Impulses Through Currencies Play Relative Impulses Through Currencies More generally, can the mild tailwind in China counter the headwinds in the West? No. Despite the improvement in China, the aggregate global bond yield impulse still constitutes a +50 bps headwind, which is almost certain to weigh down the global credit impulse through the early months of 2020 (Chart I-8). Chart I-8The Global Credit 6-Month Impulse Will Weaken In Early 2020 The Global Credit 6-Month Impulse Will Weaken In Early 2020 The Global Credit 6-Month Impulse Will Weaken In Early 2020 Therefore, as discussed last week in Strong Headwind Warrants Caution In H1, we recommend an underweight stance to banks and to the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. This is not to say that these positions cannot do better on a 12-month view, as per the BCA house view. But if so, any outperformance will be back-end loaded, and there will be a better time to enter these positions later in the year when 6-month impulses are improving. Where Is The Value In Europe? One of the most common questions we get is: are European equities cheaper than US equities? Usually, this question comes from our US clients who are aware that their own stock market is expensive and wish that Europe might be less so. Unfortunately, the wishful thinking won’t make it come true! Major stock market indexes comprise multinational companies with global footprints. For these multinationals, there is no such thing as a ‘European’ company or a ‘US’ company. They are simply global companies that could list their shares on any major stock market. Now ask yourself this: is it really plausible that such a multinational would be cheaper if its primary listing was in Frankfurt as opposed to New York? Of course not. The valuation depends on the industry and company specifics, but it is highly unlikely to depend on whether the company is listed in Frankfurt or New York. It is not European equities that are cheap, it is European currencies that are cheap. But then why do companies with dual listings in Europe and outside Europe trade at a valuation discount in their European listing? For example, Carnival Cruises trades around 8 percent dearer in New York than in London (Chart I-9); and BHP Billiton trades around 15 percent dearer in Sydney than in London (Chart I-10). The answer is that the London listing is quoted in pounds, the New York listing is quoted in US dollars, the Sydney listing is quoted in Australian dollars, but Carnival’s and BHP’s sales and profits are denominated in a mix of international currencies. Chart I-9Carnival Cruises Trades Dearer In New York Than In London Carnival Cruises Trades Dearer In New York Than In London Carnival Cruises Trades Dearer In New York Than In London Chart I-10BHP Trades Dearer In Sydney ##br##Than In London BHP Trades Dearer In Sydney Than In London BHP Trades Dearer In Sydney Than In London Hence, Carnival and BHP are trading dearer in New York and Sydney because the market is expecting their mixed currency earnings to appreciate more in US dollar and Australian dollar terms respectively than in pound terms. Put another way, the market is expecting the pound to appreciate structurally versus the major non-European currencies. Therein lies the important message. It is not European equities that are cheap, it is European currencies that are cheap. For those of you still in doubt, just visit the ECB website. The central bank’s own currency valuation indicator admits that the trade-weighted euro is 10 percent undervalued (Chart I-11). Chart I-11The ECB Admits That The Euro Is 10 Percent Undervalued The ECB Admits That The Euro Is 10 Percent Undervalued The ECB Admits That The Euro Is 10 Percent Undervalued Hence, investors seeking value in Europe should not focus on the main equity indexes. Instead, they should focus on the main currencies. That said, valuation based investing only works if you have a long enough time horizon, meaning at least two years. For shorter horizons, economic momentum and technical factors dominate. In this regard, the pound’s strong rally faces resistance once post-Brexit trade deal negotiations begin in earnest after January 31. As a tactical trade, go long EUR/GBP (see next section). Fractal Trading System* The Brexit deal unleashed a strong rally in the pound, but this is vulnerable to a countertrend setback once the trade deal negotiations begin in earnest. Accordingly, this week's recommendation is long EUR/GBP. Set a profit target at 2 percent with a symmetrical stop-loss. In other trades, long tin achieved its 5 percent profit target at which it was closed. The rolling 1-year win ratio stands at 62 percent. Chart I-12EUR/GBP EUR/GBP EUR/GBP 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 Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal   Cyclical Recommendations Structural Recommendations Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal Europe And China Play A Role-Reversal 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 The recently signed Phase One deal is positive for China and global equity markets as it brings a temporary truce to the trade war. However, China is unlikely to change its current policy trajectory to create additional domestic demand to consume $200 billion in new imports from the US. China is likely to meet the commitment only half way in the next two years, and meet the 2020 import target from the US by a redistribution of its purchases overseas. The RMB will modestly appreciate in the next three to six months. On the monetary policy front, there is no sign of further monetary easing from the PBoC. We continue to recommend an overweight stance towards Chinese stocks in the next six months, relative to the global benchmark. Feature Economic data released last week, including Q4 GDP growth, December industrial production, fixed-asset investment and trade data, all suggest that the Chinese economy bottomed before the end of 2019. The Phase One trade deal between China and the US marks a significant de-escalation in a two-year trade war. The RMB appreciated by 1.4% against the greenback since the beginning of the year, pushing USD-CNY firmly below the key psychological 7 mark. The performance of equities in China’s onshore and offshore markets confirms that the economy has bottomed. Since December 11, 2019, Chinese cyclical sectors have outperformed defensives and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks (Chart 1A and 1B). Chart 1ABoth Onshore And Offshore Equities Signal A Bottoming In China's Economy Both Onshore And Offshore Equities Signal A Bottoming In China's Economy Both Onshore And Offshore Equities Signal A Bottoming In China's Economy Chart 1BCyclicals Have Significantly Outperformed Defensives Lately Cyclicals Have Significantly Outperformed Defensives Lately Cyclicals Have Significantly Outperformed Defensives Lately We continue to recommend a cyclical long stance on Chinese stocks. We expect pro-growth policy support to accelerate in the first quarter, economic recovery to further solidify, and the Phase One trade deal to reduce economic and financial market volatility until the November 2020 US presidential election. All of these factors should support an outperformance in Chinese stocks relative to their global peers. Some Inconvenient Truth To The Truce China’s commitment to purchase an additional $200 billion in goods from the US was more than market participants anticipated. We do not think China will honor this commitment to its full extent. Moreover, we also do not think this will change China’s domestic economic policy trajectory for 2020. Details in Chapter 6 of the Phase One trade agreement titled “Expanding Trade”1 include: In the next 2 years, China is committed to purchase an additional $200 billion worth of goods and services from the US, from the 2017 baseline. The additional $200 billion amount is split over the next two years: China will need to add no less than $77 billion of imports from the US in 2020, and $123 billion in 2021. This amounts to a 41% increase in 2020 and a 66% increase in 2021, from the 2017 baseline of $186 billion (Chart 2). The text from Chapter 6 of the Phase One deal also specifies that, between January 2020 and December 2021, China will add a total of $77.7 billion in purchases of manufactured goods (including aircraft components), $32 billion in agricultural products, $52.4 billion in energy and $37.9 billion in services from the US (Chart 3). Chart 2Phase One Trade Deal Sets An Ambitious Import Target For The Next Two Years Phase One Trade Deal Sets An Ambitious Import Target For The Next Two Years Phase One Trade Deal Sets An Ambitious Import Target For The Next Two Years Chart 3Chinese Imports Of Agro And Energy Goods From The US Likely To See The Biggest Increase In 2020 From 2019 Chinese Imports Of Agro And Energy Goods From The US Likely To See The Biggest Increase In 2020 From 2019 Chinese Imports Of Agro And Energy Goods From The US Likely To See The Biggest Increase In 2020 From 2019   China’s annual import growth from the US in 2017 was the highest one in the past ten years.  If we assume that China will simply add $200 billion of new imports in the next two years from the US to this high starting point, it will need to boost domestic demand to accommodate at least a 4-6% increase in total imports in the next two years from 2019.2 In contrast, growth in China’s total imports in 2019 contracted by 3% from 2018, and averaged at only 2% in the last five years. In other words, in 2020 and 2021, even if China does not increase imports from other countries, just the commitment from purchases of US goods alone would require a sizable boost in China’s domestic demand. However, the assumption above is overly simplified and optimistic. Even though Chinese leadership may have shifted their policy priority from financial deleveraging to supporting economic growth this year, we do not think they will fully abandon the battle against systemic risks in the financial sector. Therefore, China is unlikely to significantly deviate from its current policy trajectory and stimulate aggressively to create additional domestic demand to consume the agreed $200 billion in new imports from the US. It is equally unlikely that China will absorb the $200 billion additional imports from the US, at the expense of its domestic production. A more plausible approach, which is our base case scenario, is that China will meet a large portion of the 2020 import target before November, to show good faith. After the US presidential election, China will face the challenge of either a re-escalation from the Phase Two trade talk with a re-elected President Trump, or a new US president with his/her own political agenda. In either case, at this point China is unlikely to have the intention to meet the import target for 2021. Chart 4China Likely To Shift Agro And Energy Import Suppliers To The US Managing Expectations Managing Expectations In 2020, to absorb a $77 billion additional imports from the US, China will likely shift some of its imports, such as agriculture and energy products, from other countries to suppliers in the US. China currently imports $150 billion of agriculture goods and $298 billion of energy related products on an annual basis, so the pie is large enough to absorb some of increased import commitments by shifting the sources of imports (Chart 4). The same logic goes for the manufactured goods category in the trade agreement, which includes cars, airplanes, steel, industrial machinery, and so on.3 China is likely to choose to shift its import suppliers of these goods to the US, while increasing its own share of intermediate goods supplies to the US manufacturers. Almost all of the eight subcategories under the manufactured goods category in the Phase One trade agreement are deeply integrated in the global supply chain. For example, foreign value-added share accounts for 23% of the total output value of the US automobile industry.4 In other words, if a “Made in America” car is worth $20,000, $4,600 is produced by foreign suppliers of intermediate goods. Since China has been the leading source of this foreign value-added in the US automobile industry, a sizeable slice of these additional imports will likely benefit Chinese manufacturers. In this scenario, we expect an increase in bilateral trade between China and the US in 2020, at the expense of other players in the global supply chain. Lastly, while this is not our base case scenario, it is possible the Phase One trade agreement was set up for failure, if China is simply hoping to delay the imposition of additional tariffs as part of a gamble that President Trump will not be re-elected. In this scenario, China might not make any meaningful additional purchases from the US even in 2020 (while claiming that they will be made closer to the election), implying that bilateral trade between China and the US will only revert to its historical average this year, at best. Bottom Line: Chinese policymakers are unlikely willing to alter their existing policy trajectory when accommodating more imports of US goods. China will, at best, reshuffle its supply chain to absorb a portion of the commitment before November 2020. The RMB And Monetary Policy: A Refocus On The Economic Fundamentals As tensions from the US-China trade war abate, investors are starting to refocus on economic fundamentals. The RMB has appreciated by 1.4% against the USD since the beginning of this year (Chart 5). The recent appreciation in the currency is a reversal to its fair value, which reflects an ongoing economic recovery (Chart 6). In the next three to six months, the improvement in China’s economic fundamentals and market sentiment should support a continuation in the RMB’s reversal to its structural trend. Chart 5USD/CNY Has Durably Fallen Below 7 USD/CNY Has Durably Fallen Below 7 USD/CNY Has Durably Fallen Below 7 Chart 6The Recent Appreciation In RMB Is A Reversal To Its Fair Value The Recent Appreciation In RMB Is A Reversal To Its Fair Value The Recent Appreciation In RMB Is A Reversal To Its Fair Value   But Chinese leadership’s cautious approach to boosting domestic demand will also cap the upside potential in the RMB appreciation. We think Chinese policymakers will maintain their tight grip this year on local government spending and bank lending, and will continue to fine-tune policies based on economic conditions. This will limit the magnitude in both the stimulus and economic recovery. Baring a major re-escalation in the trade war, the RMB should oscillate within a relatively narrow band through the third quarter of this year. For that reason, the PBoC is unlikely to intervene in the RMB exchange rate by significantly altering its monetary stance (Chart 7). The 3-month interbank lending rate, China’s de facto policy rate, remains low compared with the 2015-16 easing cycle. There is no sign that the PBoC will allow the rate to fall much more. The recent bank reserve requirement ratio (RRR) rate cut provides additional liquidity to the interbank system, but on a net basis liquidity does not seem excessive (Chart 8). Chart 7PBoC Unlikely To Alter Monetary Policy To Intervene RMB Exchange Rate This Year PBoC Unlikely To Alter Monetary Policy To Intervene RMB Exchange Rate This Year PBoC Unlikely To Alter Monetary Policy To Intervene RMB Exchange Rate This Year Chart 8No Sign Of Meaningful Monetary Easing From PBoC No Sign Of Meaningful Monetary Easing From PBoC No Sign Of Meaningful Monetary Easing From PBoC   Historically, the 3-month interbank lending rate only falls significantly and durably when the PBoC places consecutive RRR rate cuts (in both 2015 and mid-2018) and/or keeps net fund injections positive through the open market for a prolonged period (such as in the 2015/16 easing cycle). Chart 8 suggests the current monetary environment does not indicate that such an extremely easy stance is in place, as PBoC net fund injections through the open market remain negative. Furthermore, neither the 3-month interbank lending rate nor the 10-year government bond yield has fallen below its most recent lows in the third quarter of last year. Bottom Line: While the current environment supports a stronger RMB, the upside potential in RMB appreciation is capped by a modest scale of economic recovery. There is no sign that the PBoC is easing its monetary stance by lowering the policy rate. Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal. These two factors were confirmed in the past two weeks. Last week’s small selloffs in both onshore and offshore Chinese equity markets were likely technical corrections and pre-Chinese New Year profit taking, rather than a fundamental shift in investors’ sentiment towards Chinese stocks (Chart 9). We expect Chinese stocks to resume an upward trajectory after the Chinese New Year. Chart 9Small Corrections Following A 14% Gain Since Dec 2019 Small Corrections Following A 14% Gain Since Dec 2019 Small Corrections Following A 14% Gain Since Dec 2019 Chart 10Offshore Stocks Still Showing More Upside Potential Than Onshore Offshore Stocks Still Showing More Upside Potential Than Onshore Offshore Stocks Still Showing More Upside Potential Than Onshore China’s economic conditions and corporate earnings should continue to improve, with investable stocks showing more upside potential than their domestic counterparts (Chart 10). As growth supporting measures continue to work their way through the economy and solidify an economic recovery, China’s leadership may pull back the scale of the stimulus in the second half of the year. Therefore, the relative outperformance in both markets may be front loaded and subsequently subside in the second half of 2020. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    https://assets.bwbx.io/documents/users/iqjWHBFdfxIU/rVaHxDBUtdew/v0  2   China’s total imports of goods and services in 2019 was $2604 billion, including $168 billion imports from the US. If China was to fully meet the $200 billion target of additional imports from the US, assuming no change to imports from other countries in 2020 from 2019, China’s total imports would jump to $2699 billion in 2020 and $2745 billion in 2021. 3   The eight subcategories of Manufacturing Goods listed in the Annex 6.1 of the Phase One Trade agreement include: Industrial Machinery, Electrical Equipment and Machinery, Pharmaceutical Products, Aircraft, Vehicles, Optical and Medical Instruments, Iron and Steel, Other Manufactured Goods including solar-grade polysilicon and other organic and inorganic chemicals, hardwood lumber, integrated circuits (manufactured in US), and chemical products. 4   WIOD Data, 2016 release and OECD Input-Output Tables (IOTs), 2015 release. Cyclical Investment Stance Equity Sector Recommendations

Highlights We expect both the Australian dollar and Chinese RMB to move higher in the coming months. A key catalyst is broad-based weakness in the US dollar. The composition of goods benefiting from the US-China Phase I deal are a small portion of Australia’s export basket, limiting substitution. Remain long AUD/NZD and AUD/CAD. Place a limit buy on AUD/USD at 0.68. Feature The three key obstacles that have been hijacking currency markets are finally being addressed. First, the lack of dollar liquidity that was creating a funding crisis in repo markets has been curtailed via significant expansion of the Federal Reserve’s balance sheet. The Libor-OIS spread - a measure of banking stress - is rapidly narrowing (Chart I-1). Second, the US-China trade deal has cemented a cap on economic policy uncertainty for now. At minimum, this should allow for an increase in cross-border flows, which tends to be positive for growth. As a counter-cyclical currency, the US dollar will continue to depreciate as global growth improves. The third obstacle giving way is political risk. The biggest uncertainty for the dollar was the surge in far-left populist candidates, especially Elizabeth Warren. The result would be a highly polarized election campaign, heightening uncertainty. The near-term reaction would be a surge in safe-haven demand, even though far-left policies could significantly knock down expected returns on US assets, which would be negative for the dollar. Chart I-1An Improvement In Dollar Liquidity An Improvement In Dollar Liquidity An Improvement In Dollar Liquidity Chart I-2The Dollar And Election Outcomes The Dollar And Election Outcomes The Dollar And Election Outcomes Chart I-2 shows that the ebb and flow in the dollar in recent months has eerily matched the probability of a Donald Trump–Elizabeth Warren contest. With a centrist like former Vice President Joe Biden now likely the next democratic nominee, the likelihood of a knee-jerk rally in the dollar has subsided. Unless these risks flare up again, this suggests that for the next few months, US dollar long positions face asymmetric downside risk. This creates a growing number of trading opportunities on the short side. Australian Growth And The Fires One of the FX market’s current favorite short positions is the Australian dollar (Chart I-3). Granted, most incoming data over the past year have been negative for the Aussie dollar, and typical global reflation indicators are just beginning to show tentative signs of a bottom. Among our favorite indicators on whether or not easing liquidity conditions are fuelling higher global growth are the copper-to-gold and oil-to-gold ratios. The signal is usually strongest when they are moving in tandem with US bond yields, another global growth barometer. The message so far has been one of stabilization rather than a renewed reflation cycle (Chart I-4). Chart I-3Lots Of AUD Shorts On AUD And CNY On AUD And CNY Chart I-4Reflation Barometers Reflation Barometers Reflation Barometers The devastating fires that are sweeping through Australia are the worst in decades. As we go to press, the death toll has risen to at least 25, and the cumulative damage is expected to exceed A$4.4 billion.1 Given that we are still in the middle of the summer months, both are likely to keep ramping up. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. Tourist arrivals are already down significantly, and both business and consumer confidence are approaching fresh lows. This augurs a swift and powerful policy response. So far, at A$2 billion, the fiscal pledge will do little to alter Australia’s economic fortunes (Chart I-5). But given the scale of this season’s fires, the effects are rapidly spilling over into urban populated areas and tourist hot spots compared to the past. This suggests more fiscal stimulus will be forthcoming.  Chart I-5The Fiscal Impulse Is Minuscule The Fiscal Impulse Is Minuscule The Fiscal Impulse Is Minuscule Naturally, the odds of the Reserve Bank of Australia cutting rates at its next policy meeting are rapidly rising. The RBA views the risks from climate change through the lens of financial stability.2 With insurance companies slated to rack up significant losses, along with the immediate impact of slower economic growth, lower rates will likely be the policy of choice. The probability of a rate cut next month is currently being priced at 55%. That said, we would still be buyers of the AUD today despite an impending rate cut. Bottom Line: The latest fires have hit the Australian economy at a time when growth is weak. We expect the RBA to cut rates. How To Trade The Aussie For most small, open economies, external conditions tend to be more important for asset prices than what is happening domestically. In the case of the Australian dollar, the commodity cycle has been the most important driver (Chart I-6). Similarly, the most important catalyst for multiple expansion in Australian equities is Chinese credit demand. This makes sense, since over 35% of Australian exports go to China (Chart I-7), generating tremendous income for domestically-listed concerns. Chart I-6AUD Tracks Commodities AUD Tracks Commodities AUD Tracks Commodities Chart I-7Australian Equities And Chinese Credit Australian Equities And Chinese Credit Australian Equities And Chinese Credit Australian exports have remained resilient in recent weeks, and are unlikely to be affected much by the Phase I trade deal. This is because the composition of goods that have been spared additional tariffs or seen much-reduced export duties are mostly consumer goods that make up a small portion of Australia’s export basket. This means that the path of least resistance for Aussie assets will continue to be dictated by Chinese reflationary efforts. On that front, we have seen a number of green shoots, notably the rise in the manufacturing PMI, retail sales, imports and exports. Last night’s credit numbers were also robust. Meanwhile, interest rates in China continue to be lowered. For most small, open economies, external conditions tend to be more important for asset prices.In the case of the Australian dollar, the commodity cycle has been the most important driver. Our favorite indicator for Chinese domestic demand is the lag between the drop in bond yields (more and more credit is being intermediated through the bond market) and the pick-up in import demand. This suggests a very healthy recovery in Chinese consumption (Chart I-8). Chart I-8Chinese Imports And Bond Yields Chinese Imports And Bond Yields Chinese Imports And Bond Yields How to trade the Aussie will depend on time horizons. In the near-term, improving global growth will likely be accompanied by a weakening dollar. This means the most potent trade in the short term will be long AUD/USD. Given our bias that we will get a dovish surprise from the RBA next month, we are instituting a limit-buy on AUD/USD at 68 cents today. Over the longer term, we believe the Australian dollar will outperform its commodity-currency counterparts. In our portfolio, we are already both long AUD/CAD and AUD/NZD. This bullish view is predicated on three key developments: Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. However, the media often focuses on rising steel and iron ore prices as a catalyst for rising terms of trade in Australia. While true, often overlooked is the rising share of liquefied natural gas in the export mix (Chart I-9). Beijing has a clear environmental push to shift its economy away from coal electricity generation and towards natural gas. Given that reducing if not outright eliminating pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost (Chart I-10). In a nutshell, this is a bet that terms of trade in Australia will continue to outpace those in Canada and New Zealand over the medium-term. Chart I-9LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia LNG Will Be A Game-Changer For Australia Chart I-10A Terms-Of-Trade Tailwind A Terms-Of-Trade Tailwind A Terms-Of-Trade Tailwind Construction Activity: All things equal, natural disasters tend to be ultimately positive for GDP, since the destruction in the capital stock does not go into the GDP equation, but reconstruction efforts do. This is especially the case when the economy is running well below capacity. The downturn in Australian housing on the back of macro-prudential measures has been negative for consumption via the wealth effect and the outlook for residential construction activity. At a minimum, this downturn should stabilize as reconstruction efforts pick up (Chart I-11). Meanwhile, policy has become supportive for Aussie homebuyers at the margin. The government now guarantees first-time homebuyers in Australia below a certain income threshold access to the housing market, with just a 5% down payment instead of the standard 20%. Should labor market conditions improve, it will also help household income levels. Already, the Liberal-National coalition has left in place “negative gearing”3 and kept the capital gains tax exemption from selling properties at 50% (the pledge from the center-left Labour party was to reduce it to 25%). Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand.  Most importantly, Aussie home prices are further along their downward adjustment path than, say, Canada or New Zealand. The mirror image has been that Aussie banks have massively underperformed those in Canada (Chart I-12). Over the medium term, we could see a reversal of these fortunes. Chart I-11Capex Should Rise In Australia Capex Should Rise In Australia Capex Should Rise In Australia Chart I-12Aussie Banks Versus Canadian Banks Aussie Banks Versus Canadian Banks Aussie Banks Versus Canadian Banks Valuation And Sentiment: We will show in an upcoming report that while currency valuation is a poor timing tool, it is excellent for calibrating longer-term returns. One of our favorite metrics for gauging the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 18% (Chart I-13). In terms of currency performance, a lot of the bad news already appears priced in the Australian dollar, which is down 15% from its 2018 peak, and 37% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-14). Chart I-13AUD Is Cheap AUD Is Cheap AUD Is Cheap Chart I-14Still Lots Of AUD Shorts Still Lots Of AUD Shorts Still Lots Of AUD Shorts Bottom Line: Place a limit buy on AUD/USD at 0.68. Remain long AUD/NZD and AUD/CAD. Notes On The RMB The currency details from the Phase I trade deal were vague, suggesting monitoring export balances and FX reserves, data that is already available publicly. Our guess is that there was some kind of handshake accord agreed upon to ensure that the RMB does not depreciate significantly in the coming months. More importantly, the RMB will also be a beneficiary from increased cross-border trade, given that it has been trading like a pro-cyclical currency. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-15). It has also closely mirrored the broad trade-weighted dollar (Chart I-16).  Chart I-15CNY And EM Assets CNY And EM Assets CNY And EM Assets Chart I-16CNY And The Dollar CNY And The Dollar CNY And The Dollar This has implications for developed market currencies, since the RMB is often a signaling mechanism on the efficacy of China’s reflationary efforts. Fundamentally, the RMB has more upside. In a world of rapidly falling yields, Chinese rates remain attractive. Historically, the USD/CNY has moved in line with interest rate differentials between the US and China. The current divergence pins the USD/CNY near 6.7 (Chart I-17). Chart I-17USD/CNY Could Touch 6.7 USD/CNY Could Touch 6.7 USD/CNY Could Touch 6.7 Bottom Line: Remain positive on the RMB.  Housekeeping The Canadian dollar is one of the strongest currencies this year. The most recent catalyst was good news from the Bank of Canada’s business outlook survey, a key input into policy decisions. Canadian firms are now expecting an acceleration in both domestic and international sales throughout 2020, particularly outside the energy sector (Chart I-18, top panel). Chart I-18BoC Business Outlook Survey BoC Business Outlook Survey BoC Business Outlook Survey Hiring intentions among surveyed firms edged up in Q4. Meanwhile, many firms reported facing capacity pressures, particularly related to a shortage of labor (Chart I-18, middle panel). This will allow the BoC to overlook weak labor market data in October and November. That said, it is not all clear blue skies for the CAD. The balance of opinion for capex intentions among surveyed Canadian firms plunged in Q4 (Chart I-18, bottom panel). We will be monitoring these developments but remain short CAD/NOK and long AUD/CAD for the time being.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Keith Bradsher and Isabella Kwai, “Australia’s Fires Test Its Winning Growth Formula,” The New York Times, January 13, 2020. 2 Please see “Financial Stability Risks From Climate Change,” Financial Stability Review, Reserve Bank Of Australia, October 2019. 3 The practice of using investment properties that are generating losses to offset one’s income tax bill. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mixed: On the labor market front, nonfarm payrolls increased by 145K in December, the smallest increase since May. Average hourly earnings growth slowed to 2.9%, while the unemployment rate was unchanged at 3.5%. Lastly, initial jobless claims fell to 204K for the week ended January 10th. The NFIB business optimism index declined to 102.7 from 104.7 in December. Headline inflation increased to 2.3% year-on-year in December, while core inflation was unchanged at 2.3%. Both the NY Empire State and Philly Fed manufacturing indices rose to 4.8 and 17, respectively in January. The DXY index fell by 0.3% this week. While both headline and core inflation remain close to target, the bearish job report last Friday is likely to reduce the scope for the Fed to raise rates in the near term. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mixed: The seasonally-adjusted trade balance fell by €4.8 billion to €19.2 billion in November. Industrial production fell by 1.5% year-on-year in November. German GDP grew by 0.6% year-on-year in 2019, down from 1.5% the previous year. Car registrations rose by a remarkable 21.7% in December. The euro rose by 0.3% against the US dollar this week. "Incoming data since the last monetary policy meeting pointed to continued weak but stabilizing euro area growth dynamics," according to the ECB Meeting Accounts this Thursday. Moreover, both private and government consumption accelerated in 2019, while capex and exports slowed down. A pickup in global growth will be bullish the euro. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Both the coincident and leading indices fell to 95.1 and 90.9, respectively in November. That said, they were above expectations. The current account balance fell to ¥1,437 billion from ¥1,817 billion in November. The trade balance shifted from a surplus of ¥254 billion to a small deficit of ¥2.5 billion. The Eco Watchers' Survey recorded an improvement of current conditions to 39.8 in December, while the outlook index marginally dropped to 45.7. Preliminary machine tool orders continued to plunge by 33.6% year-on-year in December. However, machinery orders increased by 5.3% year-on-year in November. The Japanese yen depreciated by 0.4% against the US dollar this week. The recent Eco Watchers' Survey was cautiously positive on the Japanese outlook. We continue to recommend the Japanese yen as a safe-haven hedge. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been weak: Core CPI fell to 1.4% while core PPI declined to 0.9%. The total trade balance (including EU) rose from a deficit of £1.3 billion to a surplus of £4 billion in November. Industrial production fell by 1.6% year-on-year in November; manufacturing production also fell by 2% year-on-year in November. The notable improvement was in car registrations that rose 3.4% year-on-year in December. The British pound fell by 0.2% against the US dollar this week. The recent drop in inflation has undoubtedly put more pressure on the BoE to reduce rates in the coming policy meeting late January. The market is now pricing in a 66% probability for a rate cut, up from 40% a week ago, while a 25 bps cut is fully priced in by May.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services PMI fell to 48.7 from 53.7 in December. Retail sales increased by 0.9% month-on-month in November. Melbourne Institute headline inflation fell to 1.4% from 1.5% year-on-year in December. Home loans increased by 1.8% month-on-month in November, higher than expectations of a 1.4% increase. The Australian dollar is flat this week. The ongoing wildfires continue to impact the Australian economy, particularly the tourism industry. Please refer to our front section for a more in-depth analysis on Australia. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been soft: Building permits fell by 8.5% month-on-month in November. REINZ house prices grew by 1.2% month-on-month in December. The New Zealand dollar has been flat versus the US dollar this week. The recent quarterly survey from the New Zealand Institute of Economic Research (NZIER) showed that a net 21% of firms surveyed expected business conditions to deteriorate, an improvement from 40% in the previous survey. Improving data has led speculators to close NZD shorts. Stay long AUD/NZD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate fell further to 5.6% from 5.9% in December. Average hourly wage growth slowed to 3.8% from 4.4% year-on-year in December. 35.2K new jobs were created compared to a loss of 71.2K jobs the previous month. The Canadian dollar increased by 0.1% against the US dollar this week. The recent BoC Business Outlook Survey indicator edged up in Q4, lowering the probability that the BoC will cut interest rates next week. That said, the forecast for weak investment spending is worrisome. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: The unemployment rate was unchanged at 2.3% in December. The Swiss franc has appreciated by 1% against the US dollar, making it the best performing G10 currency this week. It is an open question whether the US Treasury’s move to put the Swiss franc on the currency manipulation watch list was a catalyst.  What is clear is that interventions in recent weeks have been weak. Meanwhile, the last inflation reading from Switzerland was positive, reducing the urge for the SNB to intervene. EUR/CHF is approaching our limit buy position at 1.06. Stay tuned. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: The producer price index fell by 2.2% year-on-year in November. Both headline and core inflation fell to 1.4% and 1.8% year-on-year, respectively in December. The trade surplus increased to NOK 25.6 billion from NOK 18.8 billion in December. The Norwegian krone has been flat against the US dollar this week. Both inventory reports from API and EIA have been bearish on oil prices, which put a cap on petrocurrencies this week. However, going forward, we continue to believe that the combination of expansionary monetary and fiscal policy will support commodity demand growth in 2020, which is bullish for the Norwegian krone. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production increased by 0.4% year-on-year in November. Manufacturing new orders fell by 1.2% year-on-year in November. Headline inflation was unchanged at 1.8% year-on-year in December. The Swedish krona rose by 0.2% against the US dollar this week. The Swedish government cut the forecast of GDP growth to 1.1% this year, down from the previous figure of 1.4% in September. Moreover, it forecasted negative rates going forward. That said, valuations and improving global growth will remain strong catalysts for long SEK positions. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Clients, Please note that this week we are re-publishing a Special Report written by our Emerging Market Strategy team and published on January 7, 2020. The report, authored by Ellen JingYuan He, is an extension of the Special Report published in September 2017 and examines the progress made in China’s “Belt and Road Initiative (BRI)” since its implementation in 2013.  This Special Report concludes that going forward, the Chinese government will likely shift to a stricter regulatory stance in BRI project financing. The shift will lead to a modest pullback in realized BRI investment in 2020. However, given the small size of BRI investments relative to China’s total capital spending, the recovery in Chinese capital goods imports still hinges on the domestic property and infrastructure spending cycle.  I trust you will find this report insightful. In addition, we are closing our long USD/CNH trade, initiated in May 2019 as a currency hedge for our cyclical overweight in Chinese stocks and corporate bonds (denominated in USD terms). As we mentioned in last week’s China Macro and Market Review, upon the signing of the Phase One trade deal on January 15, we expect further modest strengthening in the Chinese currency as China’s economy continues to improve. Therefore, the currency hedge is no longer needed and we recommend that investors favor Chinese stocks and bonds versus the global benchmark in unhedged terms.  Best regards, Jing Sima, China Investment Strategist   Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Chart I-11BRI Helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Remain short the DXY index. The key risk to this view is a US-led rebound in global growth, or a pickup in US inflation that tilts the Federal Reserve to a relatively more hawkish bias. Stay long a petrocurrency basket. The latest flare-up in US-Iran tensions is just a call option to an already bullish oil backdrop. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for maintaining a pro-cyclical stance. Feature The consensus view is rapidly converging to the fact that the dollar is on the precipice of a decline, and cyclical currencies are bound to outperform. This is good news for our forecast but bad news for strategy. The fact that speculators are now aggressively reducing long dollar positions, one of our favorite contrarian indicators, is disconcerting (Chart I-1). The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions (Chart I-2). That said, we are not dogmatic. In FX, momentum investors eventually get vilified, while contrarians get vindicated. This suggests revisiting the core risks to our view, especially in light of recent market developments. Chart I-1A Consensus Trade? A Consensus Trade? A Consensus Trade? Chart I-2The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency The Dollar Is A Momentum Currency An Oil Spike: US Dollar Bullish Or Bearish? The latest story on the global macro front is the possibility of an oil spike, driven by escalation in US-Iran tensions. Our geopolitical strategists believe that while Middle East tensions are likely to remain elevated for years to come, a full-scale war is not imminent.1 This view is fomented by a few key factors. First, the Iranian response to the assassination of Qasem Soleimani was relatively muted, given no US lives were claimed. This was also reinforced by the Iranian foreign minister’s claim that the actions were concluded. As we go to press, the Kyiv-bound Ukrainian aircraft that crashed in Tehran is being characterised as an “act of God” so far. In a nutshell, this suggests de-escalation. Second, sanctions against Iran have been causing real economic pain, given rampant youth unemployment and falling government revenues. This means that Tehran will have to be strategic in any confrontation with the US, since the risks domestically are asymmetrically negative. Renegotiating a new nuclear deal seems like a better bargaining chip than an all-out war. The dollar tends to be a momentum currency, so our inclination is to stay the course on short dollar positions. The biggest risk for oil prices is the possibility of a more marked drop in Iranian production, or possibly the closure of the Strait of Hormuz, though this is a low-probability event for the moment (Chart I-3). Our commodity strategists posit that while a closure of the strait could catapult prices to $100/bbl, there are some near-term offsetting factors.2 These include strategic petroleum reserves in both China and the US, as well as OPEC spare capacity that could benefit from the newly expanded pipeline to the port of Yanbu. This suggests that a flare up in US-Iran tensions remains a call option rather than a catalyst on an already bullish oil demand/supply backdrop. Chart I-3The Risk From Iran The Risk From Iran The Risk From Iran Risks to oil demand remain firmly tilted to the upside. Oil demand tends to follow the ebb and flow of the business cycle. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers, and heavy trucks to a halt (Chart I-4). Any increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. Not to mention, unplanned outages typically wipe out 1.5%-2% of global oil supply. Any such occurrence in 2020 will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-4Oil Demand And Global Growth Oil Demand And Global Growth Oil Demand And Global Growth Chart I-5Opec Spare Capacity Is Low On Oil, Growth And The Dollar On Oil, Growth And The Dollar Traditionally, a pick-up in oil prices has tended to be bearish for the US dollar. In theory, rising oil prices allow for increased government spending in oil-producing countries, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. An increase in oil prices also implies rising terms of trade, which further increases the fair value of the exchange rate. Balance-of-payment dynamics also tend to improve during oil bull markets. Altogether, these forces combine to become powerful undercurrents for petrocurrencies. That said, it is important to distinguish between malignant and benign oil price increases. There have been many recessions preceded by an oil price spike, and rising prices on the back of escalating tensions are not a recipe for being bullish petrocurrencies. That said, absent any escalating tensions or a marked pickup in global demand, which is not our base case, the rise in oil prices should be of the benign variety – pinning Brent towards $75/bbl. OPEC spare capacity remains a buffer but is very low, meaning any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints. In terms of country implications, rising oil prices will go a long way towards improving Canada’s and Norway’s trade balances. In the case of Norway, net trade fell in 2019 due to lower exports of oil and natural gas, but still stands at 5.1% of GDP. The trade balance is the primary driver of the current account balance, and the latter now stands at 4.4% of GDP. On the other hand, the Canadian trade deficit has been hovering near -1% of GDP over the past few years. Further improvement in energy product sales will require an improvement in pipeline capacity and a smaller gap between Western Canadian Select (WCS) and Brent crude oil prices (Chart I-6). We are bullish both the loonie and Norwegian krone, but have a short CAD/NOK trade as high-conviction bet on diverging economic fundamentals. Chart I-6NOK Will Outperform CAD NOK Will Outperform CAD NOK Will Outperform CAD Shifting Correlation Even though rising oil prices tend to be bullish for petrocurrencies, being long versus the US dollar requires an appropriate timing signal for a downleg in the greenback. With the US shale revolution grabbing production market share from both OPEC and non-OPEC producing countries, there has been a divergence between the price of oil and the performance of petrocurrencies. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-7).  Chart I-7Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies This is especially pivotal as the US inches towards becoming a net exporter of oil. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. The strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar down-leg. Another strategy is to be long a basket of oil producers versus oil consumers. We are long an oil currency basket versus the euro as a dollar neutral way of benefitting from rising oil prices. Chart I-8 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Chart I-8Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Buy Oil Producers Versus Oil Consumers Risks To The View Above all, the dollar remains a counter-cyclical currency. As such, when global growth rebounds, more cyclical economies benefit most from this growth dividend, and capital tends to gravitate to their respective economies. This holds true for global oil and gas sectors that tend to have a higher concentration outside of US bourses. As such, one key risk is that if the S&P 500 keeps outperforming oil, as has been the case over the past decade, the dollar is unlikely to weaken meaningfully (Chart I-9). We understand this is a call on sectors (US tech especially), rather than relative growth profiles, but what matters for currencies is the impulse of capital flows. That said, improving global growth should allow EM energy consumption (a key driver of oil prices), to pick up. Chart I-9Oil Prices And The Stock Market Oil Prices And The Stock Market Oil Prices And The Stock Market The second risk is a pickup in US inflation expectations that tilts the Fed towards a relatively more hawkish bias. The economic linkage between US inflation and oil is weak, but financial markets assign a strong correlation to the link (Chart I-10). In our view, given that higher gasoline prices tend to hurt US retail sales, and the consumer is the most important driver of the US economy, higher oil prices can only be inflationary if the overall US economy is also robust (Chart I-11). This combination is unlikely to occur if rising oil prices are being driven by a flare-up in geopolitical tensions.   Chart I-10A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations A Rise In Oil Prices Will Help Inflation Expectations Chart I-11Gasoline Prices And US Consumption Gasoline Prices And US Consumption Gasoline Prices And US Consumption A US inflation spike in 2020 is a low-probability event. There have been two powerful disinflationary forces in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. This was further exacerbated by the trade war. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-12). Meanwhile, the recent rise in the dollar and fall in commodity prices are likely to continue to anchor US inflation expectations downward, which should keep the Fed on the sidelines. Chart I-12Velocity Of Money Versus Inflation Velocity Of Money Versus Inflation Velocity Of Money Versus Inflation The gaping wedge between the US Markit and ISM PMIs remains a cause for concern. Given sampling differences, where the Markit PMI surveys more domestically-oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-13). Looking across global PMIs, there has been a notable pickup in Asia, specifically in Korea, Taiwan and Singapore, though weakness in Japan and Europe has persisted. This warrants close monitoring. Chart I-13The Risk To A Bearish Dollar View The Risk To A Bearish Dollar View The Risk To A Bearish Dollar View We continue to view further deceleration in the global manufacturing sector as a tail risk rather than our base case. Trade tensions have receded, global central banks remain very dovish, and Brexit uncertainty has diminished. This should allow global CEOs to begin deploying capital, on the back of pent-up investment spending. More importantly, the slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. On the political spectrum, it has been historically rare for the Fed to raise interest rates a few months ahead of an election cycle, which should allow a weaker dollar to help grease the global growth supply chain. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden.  Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, this remains a tail risk. Housekeeping We will soon be taking profits on our long NOK/SEK position. Reduce the target to 1.09 and tighten the stop to 1.06. Any pickup in global manufacturing activity will allow the Riksbank to adopt a more hawkish bias, narrowing interest rate differentials between Norway and Sweden. Most importantly, the cross will approach a profitable technical level in the coming weeks, on the back of our call a few weeks ago to rebuy the pair (Chart I-14). 2020 will be a year of much more tactical calls. Stay tuned. Chart I-14Take Profits On NOK/SEK Soon Take Profits On NOK/SEK Soon Take Profits On NOK/SEK Soon   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1  Please see Geopolitical Strategy Special Alert "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report "Iran Responds To US Strike; Oil Markets Remain Taut," dated January 9, 2020, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: ISM manufacturing PMI fell to 47.2 from 48.1 in December. However, Markit and ISM services PMIs both increased to 52.8 and 55, respectively.  The trade deficit narrowed by $3.8 billion to $43.1 billion in November. ADP recorded an increase of 202K workers in December, the largest increase since April. Initial jobless claims fell from 223K to 214K, better than expected. MBA mortgage applications soared by 13.5% for the week ended December 27th. The DXY index recovered by 0.7% this week from its recent decline. Trump's speech has eased tensions between the US and Iran, making an escalation towards a full-scale war unlikely. Moreover, recent data point to a continued expansion in the US through 2020. That being said, we believe that the global growth will outpace the US, which is bearish for the dollar, but this is an important risk to monitor. Tomorrow’s payroll report will be an important barometer. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been positive: Markit services PMI increased to 52.8 from 52.4 in December. Headline inflation jumped to 1.3% year-on-year from 1% in December, while core inflation was unchanged at 1.3%.  Retail sales accelerated by 2.2% year-on-year in November, from 1.7% the previous month. The Sentix investor confidence soared to 7.6 from 0.7 in January. The expectations versus the current situation component continues to point to an improving PMI over the next six months. EUR/USD fell by 0.7% this week. Recent data from the euro area have been consistent with our base case view that the euro area economy is rebounding, and is likely to accelerate in 2020. We remain long the euro, especially against the CAD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been disappointing: The manufacturing PMI fell slightly to 48.4 from 48.8 in December; the services PMI also fell to 49.4 from 50.3 in December. Labor cash earnings fell by 0.2% year-on-year in November. Consumer confidence increased to 39.1 from 38.7 in December. USD/JPY increased by 1.2% this week. The Japanese yen initially surged on the back of US-Iran headlines, then fell as tensions faded after Trump's speech. While we don't expect a full-scale war between the US and Iran for the moment, geopolitical risks will likely persist before the elections later this year. We continue to recommend the Japanese yen as a safe-haven hedge, though our long position is currently out of the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: Nationwide housing prices increased by 1.4% year-on-year in December. Halifax house prices also grew by 4% year-on-year in December. Markit services PMI surged to 50 from 49 in December. The British pound fell by 0.4% against the US dollar this week. On Thursday, BoE Governor Mark Carney said in a speech that “with the relatively limited space to cut the Bank Rate, if evidence builds that the weakness in activity could persist, risk management considerations would favor a relatively prompt response.” This has been viewed by the market as dovish and the pound fell on the message. In the long term, we like the pound as Brexit risk fades. In other news, the BoE has announced Andrew Bailey as the successor to Mark Carney, scheduled to take over in March 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The Commonwealth bank services PMI increased to 49.8 from 49.5 in December. Moreover, the AiG manufacturing index slightly increased to 48.3 from 48.1. Building permits fell by 3.8% year-on-year in November. On a monthly basis however, it increased by 11.8%. Exports increased by 2% month-on-month in November, while imports fell by 3%. The trade surplus widened to A$5.8 billion. The Australian dollar plunged by 1.5% against the US dollar amid broad US dollar strength this week. The Aussie is the weakest currency so far this year.  This is especially the case given demand destruction from the ongoing severe bushfires in Australia. On the positive side, a weaker Australian dollar could support exports and the current account as international trade picks up in 2020. The extent of fiscal stimulus will be an important wildcard for both the RBA and the AUD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mostly positive: House prices increased by 4% year-on-year in December.  The ANZ commodity price index fell by 2.8% in December. The New Zealand dollar fell by 1% against the US dollar this week. On January 1st, China's central bank announced that it would inject additional liquidity into the economy. This is bullish for global growth along with a "Phase I" trade deal. As a small open economy, New Zealand is one of the countries that will benefit the most from a global growth recovery. We will be monitoring whether the scope for improvement in agricultural commodity prices is bigger than that for bulks, which underscores our long AUD/NZD position. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been negative: Exports fell slightly by C$0.7 million in November. Imports also fell by C$1.2 million, which led to a narrower trade deficit of C$1.1 billion. Ivey PMI dropped sharply to 51.9 from 60 in December. Housing starts fell to 197K from 204K in December. Building permits also fell by 2.4% month-on-month in November. The Canadian dollar fell by 0.5% against the US dollar along with the decline in energy prices this week, erasing the gains earlier this year. While we expect the Canadian dollar to outperform the US dollar from a cyclical perspective, the CAD is likely to underperform against other cyclical currencies as global growth picks up steam through 2020. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The manufacturing PMI rose to 50.2 from 48.8 in December, the first expansion since March 2019, mainly driven by increases in both production and new orders. Headline inflation shifted back to positive territory at 0.2% year-on-year in December, following negative prints for the past two consecutive months.  Real retail sales were unchanged in November on a year-on-year basis. The Swiss franc was little changed against the US dollar this week, while it rose against other major currencies including the euro on the back of positive PMI and inflation data. More importantly, recent Middle East tensions have reignited safe-haven demand, increasing bids for the Swiss franc. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been positive: The unemployment rate fell further to 3.8% from 3.9% in October. The Norwegian krone has been fluctuating with the ebb and flow of US-Iran tensions and oil prices. This week it fell by 0.8% against the US dollar after Trump implied that both the US and Iran are backing off from an escalation into war. Moreover, the bearish oil inventory data from EIA managed to pull down oil prices even further. Despite the recent fluctuation in oil prices, we maintain an overweight stance on a cyclical basis based on a global growth recovery in 2020.  Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There has been scant data from Sweden this week:  Retail sales increased by 1.3% year-on-year in November. On a month-on-month basis however, it fell by 0.4% compared with October. The Swedish krona fell by 0.8% against the US dollar this week amid broad dollar strength. Despite rising geopolitical tensions, we remain optimistic and expect the global economy to recover this year given the US-China trade détente and increasing stimulus from China. The Swedish krona is poised to rise with global growth and a stronger manufacturing sector. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights An analysis on Indonesia is available below. We intend to maintain our long EM stocks position, initiated on December 19, as long as the MSCI EM equity index does not break below our stop point of 6% below current levels. Global trade will improve on a rate-of-change basis. Nevertheless, both money and bank asset impulses in China have already rolled over, and the credit impulse could relapse in the first half of 2020. As a result, the staying power of China’s recovery remains doubtful. For now, we continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Feature Chart I-1Investors Are Very Bullish On US Stocks Investors Are Very Bullish On US Stocks Investors Are Very Bullish On US Stocks EM share prices and currencies are at a crossroads. On one hand, some green shoots have recently emerged in Asia’s business cycle. On the other hand, global stocks are overbought and investor sentiment is very bullish, as evidenced by the record large net long position held by asset managers and leveraged funds in US equity indices futures (Chart I-1). The clash between these forces will define trading in EM risk assets in the coming weeks. If EM share prices and currencies consolidate their recent gains without a major relapse, it will signal that a sustainable rally lies ahead. Alternatively, if EM stocks and exchange rates drop considerably, it will indicate that improving investor sentiment and flows (technicals) rather than a durable recovery in corporate profitability (fundamentals) are what produced the recent rebound. We initiated a long position in EM stocks on December 19 and intend to maintain it unless the MSCI EM equity index breaks below our stop point of 1050, which is 6% below current levels. Green Shoots In Asia There are a number of green shoots beginning to emerge in Asia. December data point to a budding recovery in Asia’s business cycle: manufacturing PMIs rose in December in Korea, Taiwan and Singapore (Chart I-2). The measure was flattish in China and slightly down in Japan (Chart I-2, bottom two panels). Korean exports have begun recovering on a rate-of-change basis (Chart I-3, top panel). What’s more, the average of new and backlog orders rose for Chinese NBS and Taiwanese manufacturing PMIs in the past couple of months (Chart I-3, middle and bottom panels). Chart I-2Green Shoots In Asia Green Shoots In Asia Green Shoots In Asia Chart I-3Asian Exports To Improve On A Rate-Of-Change Basis Asian Exports To Improve On A Rate-Of-Change Basis Asian Exports To Improve On A Rate-Of-Change Basis   Chart I-4DRAM And NAND Prices Have Improved Post December 15 Memory Prices Still Signal Sluggish Semiconductor Demand DRAM And NAND Prices Have Improved Post December 15 Memory Prices Still Signal Sluggish Semiconductor Demand DRAM And NAND Prices Have Improved Post December 15 Finally, following the announcement of the US-China phase one trade deal on December 13, semiconductor NAND and DRAM prices rose (Chart I-4). It seems that the phase one trade deal has boosted sentiment not only among investors worldwide but also among business executives in Asia. Even though US ISM and European PMI manufacturing data remain lackluster, we continue to emphasize that what matters for – and is an indication of – EM growth is China’s and emerging Asia’s manufacturing cycles. In a nutshell, we put much more weight on Asian rather than DM manufacturing data when gauging trends in EM stocks and currencies. The marginal improvement in Asian manufacturing provides veracity to the recent rally in EM equities and currencies. Chart I-5China: Credit And Fiscal Versus Broad Money Impulses China: Credit And Fiscal Versus Broad Money Impulses China: Credit And Fiscal Versus Broad Money Impulses China’s credit and fiscal impulse continues to point up (Chart I-5, top panel), also supporting the notion that global trade will be improving on a rate-of-change basis. In addition, we have entered the second year of the global trade/manufacturing contraction, and the base effects are much more benign – Asian exports started shrinking in late 2018. Hence, odds are that global trade will be contracting at a reduced pace from a year ago, and by mid-2020 may even post slightly positive growth. Looking beyond the near term, however, the Chinese money and bank asset impulses have already rolled over (Chart I-5, middle and bottom panels). Given that they have often led the credit and fiscal spending impulse, odds are that the latter will roll over in the coming months. If this is indeed the case, the improvement in China’s growth will be short-lived. What does it all mean? Investors should play this EM rally with tight stop points. The near-term growth outlook is benign, but the sustainability of this recovery is not yet assured. Having rebounded in recent months, EM financial markets could soon start looking through the current improvement in economic conditions in China and could become preoccupied with its growth outlook in the second half of 2020. Market Signals Are Mixed Apart from China’s money and credit impulses, we are watching numerous market signals to corroborate or reject the hypothesis of a durable recovery in both China’s business cycle and global trade. Several of these market signals have not yet confirmed this hypothesis. Chinese and Korean government bond yields have drifted lower in recent weeks, a phenomenon that is typically associated with weakening growth in China and global trade (Chart I-6). Apart from semiconductor stocks, global cyclical sectors have not outperformed the global equity index. Specifically, global industrials, materials, autos, as well as freight and logistics, have been flat to down versus the global aggregate stock index (Chart I-7). Chart I-6Yellow Flags From Bond Yields In China And Korea Yellow Flags From Bond Yields In China And Korea Yellow Flags From Bond Yields In China And Korea Chart I-7Global Cyclicals Have Not Outperformed Yet Global Cyclicals Have Not Outperformed Yet Global Cyclicals Have Not Outperformed Yet Chart I-8No Breakout In Industrial Metals Prices No Breakout In Industrial Metals Prices No Breakout In Industrial Metals Prices Industrial metals in general – and copper prices in particular – have not yet broken out (Chart I-8). Correspondingly, the broad trade-weighted US dollar has corrected sharply but has not yet broken down. So far, the greenback’s retrenchment is more consistent with a correction rather than a bear market. A breakout in industrial metals prices and a breakdown in the broad trade-weighted dollar would confirm that China’s growth and global trade have entered a period of lasting expansion. Finally, our Risk-On/Safe-Haven currency ratio1 has so far been inconclusive. This ratio strongly correlates with the EM equity index (Chart I-9). Barring a major breakout in this indicator, the medium- and long-term outlook for EM stocks will remain opaque. Chart I-9Cyclical Versus Safe-Haven Currencies And EM Stocks Cyclical Versus Safe-Haven Currencies And EM Stocks Cyclical Versus Safe-Haven Currencies And EM Stocks Bottom Line: While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. In the coming weeks, price actions in EM financial markets will reveal if EM stocks and currencies have entered a genuine and lasting bull market or if their recent rebound has been driven by euphoria surrounding the US-China trade deal. Asset Allocation: EM Versus DM We recommended buying EM stocks on December 19 but we stopped short of outright upgrading EM versus DM stocks. We are seeking confirmation from the market signals listed above before upgrading our allocation to EM within a global equity portfolio from underweight to overweight. While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. First, EM per-share earnings (EPS) continue to underperform DM EPS in both local and common currency terms (Chart I-10). So long as EM EPS lag DM peers, EM equities, currencies and credit markets will trail their DM counterparts. Second, growth woes in EM are not limited to China or global trade. Domestic demand in many EM economies outside China, Korea and Taiwan continues to slump (Chart I-11, top and middle panel). Besides, core inflation has fallen to a record low, dampening corporate profits (Chart I-11, bottom panel). Chart I-10EM EPS Continues To Lag DM EM EPS Continues To Lag DM EM EPS Continues To Lag DM Chart I-11EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak Chart I-12EM Ex-China, Korea And Taiwan: Need Lower Lending Rates EM Ex-China, Korea And Taiwan: Need Lower Lending Rates EM Ex-China, Korea And Taiwan: Need Lower Lending Rates Even though EM central banks have reduced interest rates, in many economies lending rates in real, inflation-adjusted terms have risen rather than declined (Chart I-12). The basis is that inflation has dropped more than lending rates. High lending rates explain why credit demand is poor. In a nutshell, many EM economies require much more easing to recover. Third, EM equity valuations are not more attractive than DM ones. While EM stocks are cheaper compared to their US counterparts, they are more expensive versus euro area equities. Overall, EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts (Chart I-13). In short, there is no strong valuation case for favoring EM versus DM. Finally, we have been speculating since March 2019 that the absolute and relative performance of EM stocks is more likely to resemble their profiles in 2011-14 rather than in 2016-17. This thesis has so far been playing out. Chart I-14 illustrates an overlay of share prices in EM and DM as well as EM’s relative equity performance to DM. The overlay compares the period from 2017 to present with the one from 2011-14. Chart I-13EM Equities Command Neutral Valuations EM Equities Command Neutral Valuations EM Equities Command Neutral Valuations Chart I-14EM And DM Stocks Are Tracking Their 2012 Profiles EM And DM Stocks Are Tracking Their 2012 Profiles EM And DM Stocks Are Tracking Their 2012 Profiles   DM share prices rallied substantially in 2011-14 but EM equities, currencies and credit markets as well as commodities prices have been flat to down. As a result, EM massively underperformed DM during that global bull market (Chart I-14, bottom panel). EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts. That occurred because EM domestic fundamentals were poor back in 2011-14 and China’s growth stabilized but failed to stage a meaningful recovery (please refer to the bottom panel of Chart I-2 on page 2). Bottom Line: We continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Review Of Some Of Our Open Positions We are closing the following strategic position: short EM equities / long US 30-year Treasurys. In the past 10 years, US bonds have done much better than EM equities on a total return basis in common currency terms (Chart I-15). This position had been profitable till October but our gains have evaporated since then and we are closing it flat. We are booking a 8.3% gain on long Asian / short US semiconductor stocks, a position initiated on June 13, 2019. Asian semis stocks have already rallied a lot and potential weakness in the US dollar will help US semis while cap upside in Asian semis stocks. We are reiterating the long gold / short oil and copper trade recommended on July 11, 2019 (Chart I-16). In any feasible global macro scenario, gold will continue outperforming oil and copper. The basis is that global real interest rates will stay low. Chart I-15Close Short EM Equities / Long US 30-Year Treasurys Position Close Short EM Equities / Long US 30-Year Treasurys Position Close Short EM Equities / Long US 30-Year Treasurys Position Chart I-16Stay With Long Gold / Short Oil And Copper Trade Go Long Gold / Short Copper And Oil Stay With Long Gold / Short Oil And Copper Trade Go Long Gold / Short Copper And Oil Stay With Long Gold / Short Oil And Copper Trade   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Struggling Under High Real Rates Indonesian commercial banks have been the only leg holding up the Indonesian stock market (Chart II-1). However, their cyclical outlook is uninspiring as their share prices risk selling off. The critical issue is that lending rates in the Indonesian economy are too high for borrowers. Hence, banks are facing a lose-lose dilemma: Either bank lending rates will have to drop, squeezing Indonesian commercial banks’ net interest rate margins, or non-performing loans (NPL) will mushroom as debtors cannot afford such high borrowing costs. In both cases, bank profits will suffer. Both of these scenarios are bearish for commercial banks’ share prices. Given that banks account for 47% of the overall MSCI Indonesia stock market capitalization and the rest of the equity market has been struggling due to worsening corporate profitability, the outlook for this bourse is downbeat. We continue recommending underweighting Indonesian stocks within an EM equity portfolio. The Indonesian economy is facing strong deflationary pressures. Both headline and core consumer price inflation have dropped to the bottom of the central bank’s inflation target band (Chart II-2, top panel). Meanwhile, corporate pricing power as measured by the GDP deflator has weakened significantly (Chart II-2, bottom panel). Chart II-1Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Chart II-2Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting   Disinflationary forces have caused the nation’s nominal GDP growth to plummet dangerously below bank lending rates (Chart II-3). This makes it more difficult for borrowers to service their debt and will ensure rising NPL in the banking system. Crucially, it also discourages new credit demand. The top panel of Chart II-4 shows that bank loan growth is decelerating. Chart II-3Borrowing Costs Are Excessive Borrowing Costs Are Excessive Borrowing Costs Are Excessive Chart II-4Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates     Although the central bank has cut its policy rate by 100 basis points in 2019, bank lending rates dropped by only 17 basis points and currently stand at 10.2% in nominal terms (Chart II-4, middle panel). In real (inflation-adjusted) terms, bank lending rates remain very elevated (Chart II-4, bottom panel). Consistent with excessive borrowing costs, both the consumer and business sectors are struggling: Retail sales (excluding vehicles) volume growth is hovering around zero (Chart II-5, top panel). Retail sales of specific items are contracting (Chart II-5, middle panel). Meanwhile, motorcycle and car unit sales are shrinking (Chart II-5, bottom panel). Industrial activity is also lackluster. Freight traffic is very weak, capital goods imports are contracting and domestic cement consumption remains anemic (Chart II-6). Consistently, EBITDA of non-financial publically-listed companies is flirting with contraction (Chart II-7). Chart II-5A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector Chart II-6Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued   Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. The government is focused on keeping the budget deficit in check and no major fiscal stimulus should be expected. Therefore, monetary policy/lower interest rates should be the only source of stimulus. Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. With rate cuts by the central bank failing to translate into much lower bank lending rates, the sole viable option for authorities is to force commercial banks to reduce their lending rates. This strategy appears to be already in place, as demonstrated by President Joko Widodo’s November speech where he explicitly encouraged commercial banks to lower their lending rates. Such moral suasion or regulatory push by the authorities will likely intensify in the coming months. Doing so, however, will squeeze commercial banks’ net interest rate margins and hit banks’ profits (Chart II-8). Alternatively, if banks refuse to drop their lending rates meaningfully, their NPL will proliferate, damaging their profits.  Chart II-7Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Chart II-8Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall   Importantly, Indonesian commercial banks are expensive with a PBV ratio of 2.7; therefore, banks’ share prices will be extremely sensitive to negative news regarding their profit growth outlook. Investment Recommendations Chart II-9Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Equity investors should continue underweighting this bourse. Chart II-9 shows that relative equity performance versus EM is teetering. Our short position in the rupiah versus the US dollar remains in place but we are instituting a stop point at 13500 USD/IDR to manage risks. The basis for rupiah depreciation is as follows: In an economy that is facing unbearable high real borrowing costs and no willingness or ability to stimulate fiscally, the currency will likely serve as an adjustment valve. It will probably depreciate to boost exports and encourage import substitution as well as generate inflation. Critically, when the economy is stumbling due to excessive real interest rates, the latter do not typically engineer currency appreciation. In fact, the currency tends to depreciate rather than appreciate in cases when the return on capital is below borrowing costs. Indonesia fits this profile very well. Consistent with our expectations for currency depreciation, we continue underweighting Indonesian domestic bonds and sovereign credit within their respective EM benchmarks. We will alter this stance if our stop on the rupiah is triggered. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1    Average of CAD, AUD, NZD, BRL, MXN, RUB, CLP & ZAR total return indices relative to average OF JPY & CHF total return indices. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Incoming economic data suggests that China’s economy is in the process of bottoming, but also that the intensity of a recovery is likely to be more muted than it has been during past economic cycles. Recent Chinese equity market performance is consistent with a bottoming in the economy: cyclicals are outperforming defensives, and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark. However, there is more potential upside for investable than domestic stocks, and the gains in both markets may be front loaded in the first half of the year. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, several indicators now suggest that China’s economy is in the process of bottoming, but these indicators also imply that the intensity of a recovery in economic activity is likely to be more muted than it has been during past economic cycles. We see this as consistent with the views presented in our December 11 Weekly Report,1 which laid out four key themes for China and its financial markets for 2020. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, recent developments are also consistent with the view that Chinese economic activity will modestly accelerate and that a Sino-American trade truce will last until the US presidential election in November 2020. Chinese stocks have rallied both in absolute terms and relative to global equities over the past month, and cyclical stocks are clearly outperforming defensives on an equally-weighted basis in both markets. The RMB has also appreciated modestly, with USD-CNY having now durably fallen back below the 7 mark. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark, with the caveat that we expect more potential upside for investable than domestic stocks and the gains in both markets may be front loaded in the first half of the year. We expect modest further gains in the RMB over the coming few months, as we see the PBoC is unwilling to allow rapid appreciation. In reference to Tables 1 and 2, we provide several detailed observations below concerning developments in China’s macro and financial market data: Chart 1A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway On a smoothed basis, the Bloomberg Li Keqiang index (LKI) rose in November, driven largely by an improvement in electricity output (Chart 1). While our alternative LKI is weaker than Bloomberg’s measure, we see the improvement in the latter as a sign of a bottoming process for growth that is now underway (Bottom panel, Chart 1). Our leading indicator for the Li Keqiang index was essentially flat in November, with the large gap that has persisted between the degree of monetary accommodation and money & credit growth still present. There was a notable improvement in the Bloomberg Monetary Conditions Index (MCI) in November, but this can be attributed to a surge in headline inflation (which depressed real interest rates). This underscores that the ongoing uptrend in our LKI leading indicator is modest, and that an improvement in economic activity this year is thus unlikely to be sharp or intense. With the pace of pledged supplementary lending (PSL) injections and Tier 1 housing price appreciation as exceptions, all of the housing market data series that we track in Table 1 deteriorated in November. On a smoothed basis, residential housing sales rose at a slower pace and the previous surge in housing construction waned, in line with our expectation (Chart 2). House prices have continued to deviate from housing sales; deteriorating affordability and tight housing regulations have contributed to this divergence. Although funding from the PBoC’s PSL program improved in November, even further funding assistance is likely necessary in order to expect a strong uptrend in housing sales given the affordability and regulatory headwinds (Bottom panel, Chart 2). Both China’s Caixin and official manufacturing PMIs continue to signal positive signs for Chinese economic activity. While the Caixin PMI fell slightly in December, it stayed in expansionary territory for the fifth consecutive month. The official PMI also provided positive signs: the overall index remained above 50 for the second month, the production component rose further into expansionary territory, and the new export orders moved above the 50 mark. All told, China’s PMI data now clearly suggests that a bottoming in China’s economic growth is underway. Although the overall PMI data is sending a positive signal, Chart 3 highlights two series that are somewhat less positive. First, while the import component of the official PMI is rising, it is lagging other key sub-components and remains below 50. In addition, the PMI for small enterprises, which led the early phase of the 2016 recovery in the official PMI, has not meaningfully changed over the past few months. For now, these series suggest that a recovery in growth is likely to be muted compared with previous episodes over the past decade. Chart 2More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales Chart 3Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery In USD terms, China’s equity markets (both investable and domestic) have rallied more than 8%-9% in absolute terms over the past month. In relative terms, both investable and A-share markets have also outperformed the global benchmark. It is notable that the relative performance trend of Chinese investable stocks has broken clearly above its 200-day moving average, which is the first time since the trade talks collapsed in May of last year (Chart 4A). The strong rally in China’s stock prices over the past month, particularly in the investable market, largely reflect the likely signing of a trade truce between the US and China. In our view, more accommodative monetary and fiscal support in 2020, as well as an ongoing truce, provide a sound basis to overweight China’s stocks within a global equity portfolio over both a tactical and cyclical horizon. However, we expect that China’s investable market has more upside potential than its domestic peer, given how much further the former fell in 2019.    From an equity sector perspective, the most notable development over the past month is that cyclical sectors have outperformed defensives in both the investable and domestic markets and have broken above their respective 200-day moving averages (Chart 4B). Among cyclical sectors, industrials, energy, consumer discretionary, especially materials and telecommunication services, have all contributed to cyclical outperformance over the past month. The outperformance of cyclical sectors is strongly consistent with continued outperformance of Chinese stocks versus the global average, and strengthens our conviction that investors should be overweight Chinese markets within a regional equity portfolio. China’s 3-month repo rate fell meaningfully over the past week, in response to a 50 bps cut in the reserve requirement ratio (RRR). The decline has merely returned the repo rate back to the level that prevailed on average in 2019, but it does underscore the PBoC’s desire to modestly ease liquidity on a net basis. We will be presenting a Special Report on China’s government bond market later this month, but for now, our view remains that easier monetary policy is unlikely to materially impact Chinese government bond yields this year, unless the PBoC decides to target sharply lower interbank repo rates (which is not our expectation). Chart 4AThe Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal Chart 4BThe Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery China’s onshore corporate bond spread has risen slightly over the past month alongside falling corporate yields. Despite persistent concerns of rising defaults on China’s onshore corporate bonds, the overall default rate remains quite low compared with those in developed economies, and China’s corporate bond market will benefit from even a modest improvement in economic growth this year. As such, we expect a continued uptrend in China’s onshore corporate bond total return index, and would favor onshore corporate over duration-matched Chinese government bonds. Chart 5A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely The RMB has gained more than 1.35% versus the U.S. dollar over the last month, which caused USD-CNY to durably break below 7 (Chart 5). The rise was clearly in response to news that the US and China will agree to a trade truce, and we expect a further modest downtrend in USD-CNY as China’s economy continues to improve. Investors should note that we are likely to close our long USD-CNH trade (currently registering a gain of 1%) following the signing of the Phase One deal on Jan 15, given that we opened the trade as a currency hedge for our overweight towards Chinese stocks (denominated in USD terms). As such, upon the signing of the deal, we would recommend that investors favor Chinese stocks versus the global benchmark in unhedged terms.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations