Developed Countries

Highlights Economic conditions are quite bad, … : Stay-at-home orders have decimated economic activity, giving rise to massive layoffs. … but policy makers embarked on a mighty initial effort to limit the longer-run effects: Mixing emergency GFC programs with bold new initiatives, the Fed has kept markets functioning and restrained defaults. Congress did its part with the CARES Act, opening the fiscal taps full blast to ease the burden on struggling households and businesses. Now the key question is if they’ll have the stomach to do more: Several businesses will not reopen, and it will be some time before nonfarm payrolls regain their peak. Successive waves of monetary and fiscal accommodation may be required to prevent longer-term scarring. Feature If we could have just one data series to assess the health of the economy, we would choose the monthly employment situation report. Though employment is only a coincident indicator, it is a powerfully self-reinforcing series, influencing consumption (Chart 1), fixed investment and future hiring. The unemployment rate also drives most household credit performance models, thereby influencing banks’ willingness to make auto, credit card and mortgage loans. The ripple effects of job losses can lead to a broader tightening of financial conditions, exacerbating downturns. Chart 1As Goes Employment, So Goes Consumption The April release was grim. The headline unemployment rate leaped by ten percentage points to 14.7%, its highest level since the Depression, but it failed to convey the full picture. With greater than 2% of the labor force having been laid off in each of the two weeks following the survey cut-off date, we estimate that the unemployment rate at the end of April was another four percentage points higher. There is a sizable gap between the 38.6 million workers who have filed for unemployment since mid-March and the 17.3 million newly unemployed captured in the March and April household surveys. The labor market data will get worse before it gets better, and we assume that the unemployment rate will peak above 20%. Astonishing numbers of jobs have been lost in the blink of an eye.  To avoid getting caught up in the unemployment rate’s technicalities, we are focusing on the change in employment. The establishment survey’s nonfarm payrolls series1 shrank by 21 million in March and April, or 14% from its February peak. To put the current episode into context, the 6.3% peak-to-trough decline in payrolls that played out over 25 months from February 2008 through February 2010 was previously the worst of the postwar era, dwarfing the typical recessionary payroll contraction of 1.5-3% (Chart 2). Chart 2Payrolls Have Never Shrunk Anything Like This Before Readers who’ve had their fill of the word “unprecedented” can call the employment contraction breathtaking. One mitigating factor, cited by economists inside and outside of the Fed, is that four-fifths of the layoffs have been characterized as temporary (Chart 3). That is certainly a positive, and we don’t doubt that nearly all bars, restaurants, gyms, hotels and concert venues would like to reopen. They surely planned to when stay-at-home orders were initially implemented, but things have changed over the ensuing ten weeks, and a new research paper suggests that only about three-fifths of laid-off workers will be recalled.2 Chart 3Nearly Every Laid-Off Worker Expects To Be Recalled For most of the postwar era, it took about 18 to 24 months for employment to recover its pre-recession peak. With the onset of the twenty-first century’s “jobless recoveries,” however, employment has rebounded much more slowly across cycles. After the dot-com bust and the global financial crisis, it took four and six years, respectively, to make new highs (Chart 4). The combination of manufacturing outsourcing and the ongoing automation of white-collar tasks is likely to make the slower pace of employment recovery the rule. Investors should anticipate that unemployment will linger at elevated levels through 2021 even in the event of an optimistic scenario. Chart 4Employment Doesn't Rebound Like It Used To Congress Versus The Data When employment falls, the virtuous circle in which changes in employment feed into further changes in employment becomes a vicious circle. Falling employment doesn’t just directly weigh on activity via less consumption and fixed investment; it also leads to reduced credit availability via tighter lending standards. With COVID-19 looming as a massive shock to consumer credit performance, Congress rushed to prop up the income streams of households in harm’s way. It began by sending $1,200 checks to more than 60% of taxpayers (single filers with less than $75,000 of adjusted gross income, and married couples with less than $150,000). One-off $1,200 payments could help strapped households, but the CARES Act’s more significant measure provided for a weekly $600 supplement to state unemployment benefits through the end of July. Weekly state-level benefits average about $400. When coupled with the federal supplement, unemployed workers will receive around $1,000 per week, slightly above the average weekly wage. After applying the stimulus check, the average worker will earn 10% more over his/her first three months of joblessness than s/he did when working full time. Why leave the couch when sitting in front of the TV is more lucrative than venturing outside? The Fed is deliberately aiming to keep households and businesses from defaulting. The direct payments3 and the supplemental unemployment benefits could prevent spending from falling, and consumer loan performance from weakening, as much as they otherwise would given the scale of layoffs. The Department of Labor has tracked the share of the average worker’s income that is replaced by unemployment benefits (the replacement rate) since the late nineties. During the two recessions covered by that sample period, laid-off workers received benefits amounting to just 40% of their previous income (Chart 5). Not surprisingly, consumer loan defaults surged (Chart 6). We are hopeful that credit performance through July, the expiration date of the supplemental benefit program, will be much better than simple regression analyses based on the unemployment rate would project, leaving ample room for a positive surprise. Chart 5Unemployment Benefits Typically Replace Just 40% Of Average Income ... Chart 6... But Consumer Borrowers Might Be Able To Stay Current When They Exceed It Powell Versus The Data In his 60 Minutes interview broadcast on May 17th, Fed Chair Jay Powell repeatedly indicated that the Fed is also pursuing a finger-in-the-dike strategy. Early in the interview, after lamenting the seriousness of the COVID-19 shock, he noted, “the good news is that we have policies that can go some way toward minimizing those [hysteresis-like] effects. And that’s by keeping people and businesses out of insolvency just for maybe three or six more months while the health authorities do what they can do. We can buy time with that.” He came back to the short-term-stimulus-to-prevent-long-term-impairment theme toward the end, explicitly referencing credit performance. “[W]e have tools to try to minimize the longer-run damage to the supply side of the economy. And these tools just involve keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months. And the same thing with businesses. Keeping them away from Chapter 11 if it’s available.” It seems reasonable to assume that the worst of the public health news will have passed by the fall. If employment were to rebound in line with re-opening measures, six months of active fiscal and monetary support, from March to September, ought to be enough to stave off long-run damage. As the massive scale of the job losses is revealed, however, we are beginning to rethink our own assumptions about when the economy will truly be able to stand on its own. As Chart 4 suggests, it may be unrealistic to think that the US can return to full employment by 2022, especially as the lockdowns may have given businesses lots of ideas about where they can permanently reduce headcount. The Fed is prepared for such a contingency, to hear the Chair tell it: It may well be that the Fed has to do more. It may be that Congress has to do more. And the reason we’ve got to do more is to avoid longer-run damage to the economy. [W]e’re not out of ammunition by a long shot. No, there’s really no limit to what we can do with these lending programs that we have. So there’s a lot more we can do to support the economy, and we’re committed to doing everything we can as long as we need to. Powell’s take did not come as news to markets, even if it helped stocks romp higher the day after the interview was broadcast. The Fed moved with dizzying speed in March, and its measures have been effective. Taking the corporate bond market as an example, spreads narrowed sharply after the primary- and secondary-market corporate credit facilities were announced on March 23rd (Chart 7) and have fallen to a level consistent with a run-of-the-mill recession (Chart 8). Corporate bond issuance set an all-time monthly record in March, then broke it in April, all without the Fed buying a single bond until mid-May. Chart 7The Fed Tamed The Corporate Bond Market Without Firing A Shot ... Chart 8... And Spreads Are Now At Levels Consistent With A Ho-Hum Recession Investment Implications Investors can count on the Fed’s whatever-it-takes pledge, but they shouldn’t expect the Fed to defend the economy from monumental job losses all by itself. States, cities and towns need cash grants to avoid laying off wide swaths of their workforces, and only Congress and the administration can issue them. Despite their public wavering, we do not think that Republicans will want to spurn masses of unemployed voters and their teachers, police and firefighters ahead of the election. Bailout fatigue and deficit worries will make succeeding iterations of aid packages less generous, though. A wave of defaults and business failures would complicate the near-term recovery playbook. Independent of longer-run effects, financial markets will fare better over the next year if fiscal and monetary policy continue to focus on limiting avoidable busts. We think they will, however begrudgingly, but financial markets already discount this benign outcome. Jay Powell is singing the SIFI banks' song. The combination of Fed support and low valuations makes them especially attractive. Relentlessly accentuating the positive leaves risk assets vulnerable in the near term. We continue to expect some sort of an equity correction and have no appetite for anything but the BB-rated top tier of high yield corporates. Over the tactical 0-to-3-month timeframe, we continue to recommend that multi-asset investors maintain a benchmark equity weighting, while underweighting bonds and overweighting cash. We recommend overweighting equities, underweighting bonds and equal-weighting cash over the cyclical 3-to-12-month timeframe. Within bonds, we are underweight Treasuries and high yield, and overweight investment grade, over both timeframes. The SIFI banks will benefit most directly if policymakers are able to limit consumer and business defaults. Chair Powell’s 60 Minutes refrain should have been music to their management teams’ and stockholders’ ears. They are the rare prominent segment of the market that is viewing the glass as half-empty. Investors have a considerable margin of safety buying them at or near their book value and they continue to be our favorite long idea.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The employment situation report is compiled from a survey of households (used to calculate the size of the labor force and the unemployment rate) and a survey of business establishments (used to calculate net employment gains, hours worked and earnings). The foregoing unemployment discussion referenced the household survey; the subsequent discussion and charts reference the establishment survey. 2 Barrero, Jose Maria, Nicholas Bloom and Steven J. Davis, 2020. "COVID-19 Is Also a Reallocation Shock," NBER Working Paper No. 27137. Accessed May 21, 2020. Using historical data samples analyzed by other researchers, and the responses to the Survey of Business Uncertainty, the authors estimate that only 58% of pandemic-induced layoffs will prove to be temporary. 3 Another round of direct payments is being debated on Capitol Hill as we go to press.

Overweight In our April 14 Weekly Report we executed our upgrade alert and boosted the S&P internet retail index to overweight – a call that has since produced handsome relative gains of 14%. The most recent Advance Monthly Retail Trade (AMRT) report also suggests that the path of least resistance remains up for relative share prices. In fact, non-store retailers were the only category that reported an increase in activity on a month-on-month basis, while other categories such as clothing & accessories contracted nearly 80%. Bottom Line: We heed the message from the most recent AMRT report and continue to recommend an above benchmark allocation for the S&P internet retail index. The ticker symbols for the stocks in this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.

Dear client, In lieu of our regular weekly report next week, we will hold a webcast on Thursday at 10:00 am ET discussing both tactical and strategic currency considerations. The format will be a short presentation, followed by a Q&A session. We look forward to engaging with you. Kind regards, Chester Ntonifor Vice President, Foreign Exchange Strategy Highlights Go short the Gold/Silver ratio (GSR). Hold a basket of NOK and SEK against a basket of the dollar and euro. Go long sterling. Feature Chart I-1The Dollar And Business Cycles When constructing a basket of high-conviction positions, the starting point is usually the framework used to build the portfolio. Ours is through a three-factor lens. The first lens determines what macroeconomic environment we are operating in. Think of a four-quadrant matrix, with growth on one axis and inflation on the other. Intuitively, the dollar should do best when global growth is decelerating and inflation is falling. The climatic expression of this is a deflationary bust, when all bets are off and the dollar is king. On the other side of the spectrum, the dollar should weaken as global growth rebounds (Chart I-1). The second lens is valuation. Specifically, as the drop in cyclical currencies in a deflationary bust approach a capitulation phase, value begins to put a cushion under deteriorating fundamentals. In our previous work, we showed that foreign exchange value-trading strategies based on PPP are profitable over the long term.1  Finally, technical indicators are our third lens for two reasons. First, they are the most powerful indicators for short-term trades. Second, they act as a bridge between bombed-out valuations and a subsequent improvement in macro fundamentals. For example, a saucer-shaped bottom in a cyclical currency can usually be a prelude to a U-shaped economic recovery. A high-conviction trade is one that ticks all three boxes or is agnostic to the first but has a powerful signal from both the second and third. Using this framework, we suggest two trades this week. Go Short The Gold/Silver Ratio When looking at our four-quadrant matrix, it is clear that the dollar tends to rise during a downturn, and fall early in the cycle. Intra-cycle performance is more nuanced. With both first- and second-quarter GDP likely to contract severely around the world, growth is likely to bounce back later this year if economies stay open. This should, ceteris paribus, lead to a weaker dollar. A bearish view on the dollar can be expressed by being short the GSR. The Gold/Silver ratio (GSR) tends to track the US dollar (Chart I-2), so a bearish view on the dollar can be expressed by being short the GSR. It is well known that most of the time, bullion is inversely correlated to the US dollar, not only due to the numeraire effect but also as competing monetary standards. Given that silver tends to rise and fall more explosively than the price of gold (Chart I-3), it makes sense that the GSR should inversely track the greenback. Part of the reason for silver’s explosive – albeit lagged – response is that the silver market is thinner and more volatile, with open interest in futures about one-third of gold. Chart I-2GSR And The Dollar Chart I-3Silver Has Explosive Rallies The potency of the GSR is in its leading properties, as it provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. The GSR tends to rally ahead of an economic slowdown, then peaks when growth is still weak but financial conditions are easy enough to short-circuit any liquidity trap. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Not surprisingly, the GSR has led the rise and fall of many ASEAN and Latin American currencies that are at the forefront of manufacturing (Chart I-4). Chart I-4GSR, Latam And Asean Currencies A key assumption in a lower GSR is that the global economy fends off a deeper recession, which would otherwise sustain a high and rising ratio. But even if we are wrong and the dollar remains stronger over the next 12-18 months, the valuation cushion from being short the GSR is outstanding. The ratio broke above major overhead resistance at 100 just as the dollar liquidity crunch was intensifying, and is now staging a V-shaped reversal. Historically, these reversals tend to be quick, powerful, and extremely volatile. Unless gold is entering a new paradigm versus silver, the forces of mean reversion should pull the ratio towards 50 (Chart I-5). Chart I-5Big Downside Potential For GSR The next important technical level for silver is the $18-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, and has provided strong downside support for silver prior to that. If silver is able to punch through this zone, this will help bridge the gap between silver and gold fundamentals. Globally, the world produces 24,201 tons of silver a year and 3,421 tons of gold. That is a supply ratio of 7:1. Meanwhile, the price ratio between gold and silver is 100:1. This seems like a very wide gap, given that the physical supply of silver is in deficit. Bottom Line: We have been flagging the GSR as a key indicator to watch since last year.2 Our sell-stop on the ratio was finally triggered at 100. Place stops at 110, with an initial target of 75. Go Long Sterling, In Addition To NOK And SEK If the dollar is indeed in a renewed downtrend, the most potent beneficiaries of this move will be NOK and SEK. Our basket of long Scandinavian currencies against both the dollar and the euro has a significant margin of safety, even if we are offside on the dollar trend (Chart I-6). The euro will naturally pop on dollar weakness, but a very liquid beneficiary could also be sterling. Trade negotiations between the UK and EU are clearly breaking down. The worst-case scenario is a no-deal Brexit, in which case the pound could significantly decline. The key question would be by how much? Every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20.  The first observation is that each time the odds of a “hard” Brexit have risen significantly, the threshold for cable downside has been 1.20. The first occurrence was the aftermath of the UK referendum in 2016. The second episode was when Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-7). Intuitively, this suggests that every time there has been maximum pessimism on the pound driven by Brexit fears, the line in the sand has been 1.20. Of course, a pandemic can change this dynamic, as we saw with the drop in cable to 1.15 in March, but this move was not isolated to sterling. Chart I-6SEK And NOK Are Attractive Chart I-7GBP Has Historically Bottomed At 1.2 While a no-deal Brexit is not our base case, it is still instructive to simulate cable downside in the case of  such an event. Given that the last time Britain majorly defected from a union was during the Exchange Rate Mechanism (ERM) crisis in the 1990s, revisiting this episode could be instructive. The episode leading to the collapse of the pound in 1992 has important lessons for today.3 Britain entered the ERM in October of 1990 in an attempt to find a stable nominal anchor. In other words, with high inflation and an overvalued currency, adopting German interest rates was expected to temper inflation and realign the real exchange rate. Fundamental models show the pound as being very cheap. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. As doubts towards the progress of a union began to rise, investors started to question where the shadow exchange rate for ERM currencies lay, especially the Italian lira and the Spanish peseta. Britain also massively stepped up its interventions in the foreign exchange market in August of that year, having to borrow excessively to increase reserves. Britain was eventually forced to suspend its membership in the ERM. Herein lies the key differences with today. Support for the euro within member countries is extremely strong. So, while EUR/GBP may have near-term upside, a destabilizing fall in the pound relative to the euro is unlikely. A substantial rise in the EUR/GBP, assuming little euro breakup risk, is a bet on the fact that not only is the pound misaligned versus the German “Deutschemark,” but it is also expensive versus the Italian “Lira” and Spanish “Peseta.” This seems unrealistic. The pound was overvalued as the UK entered the ERM, judging from its real effective exchange rate adjusted for consumer prices. A persistent inflation differential between the UK and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-8). Moreover, fundamental models show the pound as being very cheap, especially versus the US dollar on both a PPP and productivity basis. During the ERM crisis, most of the adjustment in the pound happened quickly, but a key difference is that it was unanticipated. Foreign exchange markets today are extremely fluid and adjust to expectations quite fast. From its peak, GBP/USD depreciated by 24% by end of October 1992. Peak to trough, cable has fallen by almost 30% today. Given this drop, it is hard to imagine that the probability of a no-deal Brexit is not priced into cable. The real effective exchange rate of the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in magnitude (24% in both episodes). In the event a deal is forged, the pound should converge toward the mid-point of its historical real effective exchange rate range, which will pin it at least 15%-20% higher (Chart I-9). Chart I-8Not Much Misalignment In U.K. Prices Today Chart I-9Cable Valuation Reflects Brexit Risk Bottom Line: Go long the pound as a trade but maintain tight stops at 1.20. Our limit sell on EUR/GBP was a whisker from being triggered this week at 0.9. While we will respect this level, long-term investors can start slowly shorting the cross.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, “Introducing An FX Trading Model,” dated April 24, 2020 avaiable at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report,  “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com. 3 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly negative: Retail sales fell by 16.4% month-on-month in April, following an 8.3% decrease the previous month. The preliminary Markit manufacturing PMI increased from 36.1 to 39.8 in May. The services PMI also improved from 26.7 to 36.9. The NAHB housing market index increased from 30 to 37 in May. This follows a contraction in building permits by 21% month-on-month in April and a 30% month-on-month drop in housing starts. Initial jobless claims kept rising by 2438K for the week ended May 15th. The DXY index fell by 1% this week. The DXY index has been stuck in a narrow trading range between 98.50 and 101, ever since the Fed’s swap liquidity programs were unveiled. This suggests a stalemate between weak global growth and improving financial conditions. Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: GDP contracted by 3.2% year-on-year in Q1. Employment fell by 0.2% quarter-on-quarter in Q1. The seasonally-adjusted trade surplus narrowed to €23.5 billion from €25.6 billion in March. The current account surplus fell from €37.8 billion to €27.4 billion. The ZEW sentiment index improved from 25.2 to 46 in May. The preliminary Markit manufacturing PMI increased from 33.4 to 39.5 in May. The services PMI also ticked up from 12 to 28.7. The euro increased by 1.7% against the US dollar this week. During a recent speech at the Institute for Monetary and Financial Stability Policy Webinar, the ECB member Philip R. Lane reinforced that the ECB will continue to constantly assess the monetary measures and is fully prepared to further adjust its instruments, which might include increasing the size of the PEPP. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: GDP plunged by 3.4% year-on-year in Q1. Industrial production fell by 5.2% year-on-year in March. Machinery orders fell by 0.7% year-on-year in March, following a 2.4% contraction in February. Exports and imports both fell by 21.9% and 7.2% year-on-year respectively in April. The total trade balance fell from a ¥5.4 billion surplus to a ¥930.4 billion deficit. The preliminary manufacturing PMI fell from 41.9 to 38.4 in May. The Japanese yen fell by 0.9% against the US dollar this week. The Bank of Japan announced on Tuesday that it will hold an emergency policy meeting on Friday, May 22nd, following the bleak GDP data on Monday. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been negative: The unemployment rate slightly decreased from 4% to 3.9% in March. Average earnings including bonuses grew by 2.4% year-on-year. Headline retail price inflation fell from 2.6% year-on-year to 1.5% year-on-year in April. The Markit manufacturing PMI increased from 32.6 to 40.6 in May. The services PMI also improved from 13.4 to 27.8. The British pound increased by 0.9% against the US dollar this week. This week saw the UK selling its long-term government bonds with negative yield for the first time in history. Moreover, the BoE has also not ruled out the possibility of negative interest rates. Please refer to our front section this week for a more detailed analysis on the pound. 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 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: The Westpac leading index fell by 1.5% month-on-month in April. Retail sales plunged by 17.9% month-on-month in April. The preliminary Commonwealth manufacturing PMI slipped from 44.1 to 42.8 in May, while the services PMI increased from 19.5 to 25.5. The Australian dollar appreciated by 2.6% against the US dollar this week. The RBA minutes released this week noted that the Australian economy had been severely affected by the COVID-19, and most of the contraction was expected to occur in the second quarter of 2020. The current economic contraction is unprecedented in the 60-year history of the Australian economy. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The Manufacturing PMI fell from 53.2 to 26.1 in April. The services PMI also plunged from 52 to 25.9. PPI output prices increased by 0.1% quarter-on-quarter in Q1, while input prices depreciated by 0.3% quarter-on-quarter. House sales plunged by 78.5% year-on-year in April. The New Zealand dollar appreciated by 3.4% against the US dollar this week, making it the best performing G10 currency. The RBNZ indicated that the recent rate cuts have not been transferred via lower mortgage rates or lower retail rates. They have also expressed concerns about a higher mortgage default rate once the 6-month mortgage repayment deferrals expire. 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 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Headline consumer prices contracted by 0.2% year-on-year in April, falling into deflationary territory for the first time since 2009. Core inflation fell from 1.6% to 1.2% year-on-year in April. Trade sales contracted by 2.2% month-on-month in March.  Existing home sales plunged by 56.8% month-on-month in April, following a 14.3% decrease in March. The Canadian dollar rose by 1.3% against the US dollar this week. Statistics Canada shows that in April, consumer prices deflation is led by transportation, clothing and footwear, which saw yearly declines of 4.1% and 4.4% respectively. However, consumers paid more for food due to higher demand. Rice, eggs and pork prices rose by 9.2%, 8.8%, and 9% year-on-year respectively in April. In addition, household cleaning products and toilet paper prices also surged in April. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 4% year-on-year in April, following a 2.7% yearly decrease in March. Total sight deposits continued to rise from CHF 669.1 billion to CHF 673.5 billion last week. The Swiss franc appreciated by 0.5% against the US dollar this week. Due to the COVID-19 pandemic, KOF published a new forecast for Switzerland in May, which now forecasts the economy to rebound gradually once the current lockdown restrictions are eased. However, tax revenues in Switzerland are expected to fall by over CHF 5.5 billion this year and CHF 25 billion over the next years. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Exports plunged by 24% year-on-year to NOK 58.8 billion in April. Imports fell by 10.8% year-on-year to NOK 55.5 billion. The trade surplus fell by 78.5% year-on-year to NOK 3.2 billion. The Norwegian krone appreciated by 3.2% against the US dollar this week, fuelled by the recent oil prices recovery. Statistics Norway showed that the recent plunge in exports was mostly led by crude oil, natural gas, and fish exports. Natural gas condensates exports, on the other hand, rose by 44.7% year-on-year in April. That being said, we remain long the Norwegian krone from the valuation perspective. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industry capacity fell slightly from 89.4% to 89.2% in Q1. Total number of employees grew by 0.3% year-on-year in Q1, compared with a 0.4% growth the previous quarter. The Swedish krona appreciated by 2.8% against the US dollar this week. In the latest Financial Stability Report released this Wednesday, the Riksbank highlighted that “if the crisis becomes prolonged, the risks to financial stability will increase”. Moreover, the Bank stated that they are ready to contribute by providing the necessary liquidity to help banks maintaining sufficient credit supply. 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

Special Report

Highlights China faces unprecedented socioeconomic challenges but its political response is rigid rather than flexible. The twin political goals of centralization and self-sufficiency bode ill for productivity. Communist Party elites have become more ideological and provincial, less cosmopolitan and technocratic. A global protectionist backlash adds to China’s woes. Over the long run, favor cyclical and commodity plays that benefit from China’s reflation but are distanced from its large and persistent political and geopolitical risks. Feature In ancient times Chinese emperors ruled with the “mandate of heaven.” As long as they could keep famine, rebellion, invasion, and plague from ravaging the nation, they were perceived as having divine sanction. Their dynasty would retain power and the people would be kept in awe (Table 1). Table 1Disease And The Fall Of Chinese Dynasties The COVID-19 pandemic and recession are highly unlikely to cause the downfall of General Secretary Xi Jinping and the Communist Party “dynasty.” But it is part of a string of recent challenges to the regime that are secular and structural in nature. The regime’s response, thus far, has been rigidity rather than flexibility – a warning sign that things may get worse before they get better. Investors should not view China as “fundamentally stable,” as has largely been the case for the past 20-30 years. Instead they should view it as fundamentally unstable and therefore a source of understated risk to the Chinese currency, equities, and corporate bonds. This is especially true relative to markets that benefit from Chinese reflation yet are distanced from its political and geopolitical risks. Political risks are more likely to manifest in China’s periphery in the short run. Mainland Chinese political risks are more likely to manifest over the long run. A Massive Reflationary Kick China convenes the National People’s Congress on May 21, after a two-month delay due to the extraordinary COVID-19 pandemic. The annual legislative session typically drives reflationary sentiment in the global economy and financial markets, especially in years of crisis such as 2009 and 2016. This year should be another such year, particularly viewed from a long-term perspective. Investors can count on massive Chinese stimulus because the spike in unemployment poses a threat to social stability. Chinese authorities are wheeling out the big guns for this crisis. The fiscal measures announced thus far should reach 10% of gross domestic product. The “quasi-fiscal” function of Chinese banks could push the total well above that when all is said and done. Investors can count on massive stimulus because the spike in unemployment poses a threat to social stability. The economy is contracting for the first time since the Cultural Revolution (Chart 1). Chart 1China's Rapid Growth, A Pillar Of Stability, Is Officially Gone Table 2The Great Chinese Boom, 1980-2020 Ever since that chaotic period, the Communist Party has based its legitimacy on economic growth and rising incomes. The results of China’s economic boom of 1980-2020 are well known. China’s share of global GDP has risen from 2% to 16%; its share of global capital stock from 3% to 21%; exports 1% to 13%; and military spending 1% to 14% (Table 2). In the future, with this economic pillar cracked, Beijing will have to devote even more attention to “stability maintenance” at home. Reflation Doesn’t Solve Structural Problems Household consumption is China’s only hope for developing sustainable economic growth in the wake of a boom driven by investment in export-manufacturing and construction. Cyclically, the virus threatens consumption by discouraging consumers from going anywhere other than work. However, China’s suppression of the virus is enabling consumers to resume activity gradually. Elsewhere, including Europe, economic expectations are also perking up, corroborating China’s data that consumers are increasingly willing to venture out of their homes (Chart 2). Still, China is vulnerable to subsequent outbreaks and is already instituting new lockdowns in the northeast. Structurally, China’s economy is susceptible to a series of historic shifts that were already taking place and that the pandemic has accelerated. The working-age share of the population is now declining rapidly. This coincides with a drop in the national savings rate (Chart 3) and a rapid rise in the dependency ratio – faster even than in Germany or Japan over the past two decades. Consumption will rise relative to investment. But if households are precautionary savers, as in Japan, then consumption will not grow fast enough to sustain overall GDP growth, forcing the government to spend more to shore up overall demand. Chart 2Chinese And Global Sentiment Recovering Chart 3China's Demographic Changes Portend Higher Cost Of Capital China no longer primarily channels its savings into export manufacturing. Instead it invests them at home. China’s total debt – public and private – has surpassed that of many developed nations despite the country’s lower level of development and wealth (Chart 4). China can manage this debt, given that it prints its own currency, keeps a closed capital account, and has shifted to a primarily domestic-oriented economy. But the debt is less manageable than before the crisis. Nominal growth has fallen beneath interest rates, implying that, in the midst of the crisis, debt cannot be serviced for the economy as a whole (Chart 5). Growth will revive, but it will likely run at lower rates than prior to the crisis. Debt servicing will be a recurrent problem for small or inefficient businesses. Chart 4China’s Indebtedness Will Continue To Surge Chart 5China Needs Growth To Service Debt Chart 6China Struggling To Avoid 'Twin Deficits' The whole problem is illustrated by China’s verging on “twin deficits” – an ever-widening budget deficit combined with a recent tendency to slip into current account deficit (Chart 6). Anglo-Saxon economies often run large twin deficits. But China is more comparable to Japan, which has never let itself run persistent current account deficits, since it would then become reliant on foreign sources of financing. Since China will run large budget deficits for the foreseeable future, it will either have to make its corporate sector more efficient (e.g. by depressing wages), or it will see downward pressure on the currency as a result of a weakening current account balance. The pandemic and recession will pass, thanks to massive stimulus. What will remain is China’s voyage into new territory. Prior to COVID-19 the concern was that China would grow old before it grows rich – that the transition to a low-growth consumer economy would occur at a much lower level of GDP per capita than it did with economies like Taiwan, Japan, and South Korea. Now, with a sudden downward shift in growth rates, it is possible that China will grow old without growing rich. This would be a huge risk to the regime in the long run. The Communist Party Returns To Its Roots Risk of economic stagnation – the so-called middle-income trap – is why policymakers at the National People’s Congress this weekend will lay so much emphasis on “reform and opening up,” even as they are forced by the pandemic to do the opposite for now and stimulate the economy via debt-financed fixed investment. China has pledged sweeping structural reforms, liberalization, and internationalization so many times now that it is common for western policymakers to complain of “promise fatigue.” The lack of verification is one reason foreign governments are increasingly willing to consider punitive measures in dealing with China. Today’s macro and geopolitical context do not favor liberal reforms, such as occurred in China in the late 1990s, but the changing characteristics of China’s elite political leaders reveal a more specific reason why policy has grown more statist, more “communist,” and less liberal, over the past decade. Members of the Politburo Standing Committee (PSC), the most powerful decision-making body, have become more ideological, more authoritarian, less cosmopolitan, and less technocratic over the years (Chart 7). They are far less likely to have studied the hard sciences or engineering than their predecessors, who orchestrated China’s westernizing, capitalist reforms from the 1980s to early 2000s. Chart 7China’s Leadership Increasingly Provincial And Inward-Looking They lack experience running state-owned enterprises, which might seem like a plus, except that the alternative is being a career politician – a ruler of a province – and never having run any business at all. Leaders increasingly hail from rural provinces, as opposed to the wealthy, internationally savvy coasts. Chart 8China Will Miss Some Centennial Income Targets Essentially, the grassroots interior of the country – the base of the Communist Party – has been reclaiming the party from the corrupt, liberal, westernizing technocrats. And the party is about to grow even more reactionary. First, it is now officially failing to meet its own development goals. For several years the administration has talked of abandoning annual GDP growth targets as part of its push to prioritize quality rather than quantity of economic growth, but has not done so. Now it is not only the annual growth target that will be missed in 2020, but the party’s decade goals will have to be fudged (Chart 8). Moreover, if the economy does not recover as quickly as hoped then the highly symbolic 2021 centennial of the Communist Party will be marred. Replacing hard numerical targets is reasonable but will not change the party’s constant need to emphasize development goals to keep the people looking forward. And it will not remove the local-level incentive structures that cause economic distortions to meet central government goals. The takeaway is that massive stimulus is assured as the party cannot afford to suffer instability over this period of political milestones. Second, the administration’s difficulties open up at least some possibility of factional struggle within the party. Remember that Xi Jinping was supposed to step down in 2022 at the twentieth National Party Congress. This would have marked the end of his ten-year rule according to the rules that his two predecessors tried to establish. Xi altered this pattern in 2017 to pave the way to rule until 2035 or beyond. Thus while the market can look forward to stimulus this year and next to ensure the economy has stabilized by 2022 (Chart 9), there is potential for surprising political events to rattle China’s appearance of political stability and unity. Chart 9Xi Jinping Was Originally Slated To Step Down In 2022 Granted, Xi has shifted the party’s governance model from single-party rule to single-person rule. The most likely political shocks will come from Xi cracking down on his opponents to re-consolidate power, as he did in 2012-13 and 2017. Factional struggles could cause minor risk-off episodes in financial markets but they will say something more important, which is that the unity of the ruling party is a façade and stability cannot be assumed forever. Economic Targets: Centralization And Autarky In the coming years, Xi Jinping’s government will continue to centralize control over society and the economy as it has done throughout his term. This is the opposite of “reform” in the sense of former leader Deng Xiaoping, which meant decentralizing power and letting local governments and private business innovate. The Xi administration’s “reform” push was to cut industrial overcapacity and deleverage the corporate sector, as we highlighted in a series of reports from 2016-18. We argued then that these reforms would be abandoned as soon as major downside risks to growth returned – which is what occurred due to the trade war and now COVID-19. Thus the net effect of the Xi administration thus far has been to centralize the economy and pursue self-sufficiency. Centralization can be shown in the resurgence of the Communist Party, the central government in Beijing, and state-owned enterprises. Government debt has grown at the expense of private leverage (Chart 10), which faced a crackdown, while the state-owned share of corporate debt has grown from one-half to two-thirds since 2013. Xi formally pledged in 2017 to make state companies stronger, better, and bigger. His term has witnessed a major bull market in SOE equities relative to the broad market – and each phase of power consolidation adds a new rally to this trend (Chart 11). Chart 10Public Sector Encroaching On Private Sector … Before COVID-19 Chart 11SOE Bull Market Under Xi Jinping As for international trade, China has become far less reliant on foreign parts and components for its manufacturing sector over recent decades (Chart 12). It has also increasingly used state resources to pursue strategic self-sufficiency through technological acquisition, import substitution, and state-backed “indigenous innovation.” The attempt to make a new Great Leap Forward in advanced manufacturing and high-tech services has led to a direct clash with the US government, which is now actively expanding export controls. In the upcoming fourteenth Five Year Plan for the years 2021-25, Beijing is highly likely to double down on technological self-reliance. Chart 12China Closes Its Doors Chart 13Centralization And Closed Economy Harm Productivity Centralization and import substitution have harmed productivity, especially total factor productivity (Chart 13). Centralization is not necessarily bad for productivity – state-directed research and development can galvanize major improvements. But in China centralization is excessive and constricts the flow of information and ideas in civil society and academia, which discourages innovation and privileges quantity over quality of output. Closure to the outside world reinforces this point – particularly as a global protectionist backlash comes to affect China’s acquisition of tech and talent – and exacerbates the misallocation of capital at home. Social Unrest Will Grow China’s falling potential growth will generate social unrest over time, despite the appearance of perfect control in this authoritarian society. Table 3 shows our COVID-19 Social Unrest Index. Countries are ranked from best to worst, top to bottom. Obviously a high rank does not suggest a country is immune to unrest – all emerging markets are vulnerable. A poor score under “household grievances” – i.e., income inequality combined with the “misery index” of high inflation and unemployment – can engender unrest even in relatively well-governed states, as is happening in Chile. Table 3China Looks Stable On Paper: Our COVID-19 Social Unrest Index China ranks fourth overall, with poor governance indicators dragging down the total. However, household grievances will rise as the unemployment rate rises (and perhaps food and fuel inflation). Unemployment is much higher in China than officially reported. The government is also unfamiliar with how to deal with large surges in unemployment, having long utilized policy to minimize the unemployment rate at any cost (Chart 14). Chart 14AUnemployment Spike A Threat To Chinese Stability Chart 14BUnemployment Spike A Threat To Chinese Stability Chart 15Income Inequality In China Inequality is at extreme levels and will worsen as a result of COVID-19. Our China Investment Strategist shows that the bifurcation in wealth between the top 10% and the bottom 50% will widen as job losses hit low-skilled and labor-intensive sectors (Chart 15). The rural-urban disparity – an obsession of policymakers in recent years – will also grow amid the crisis (Chart 16). Two factors are aggravating these trends. First, the decline of the manufacturing sector alluded to above. China’s manufacturing sector was too large and it has been rapidly converging to the level of developed economies, meaning that as many as 10% of workers’ jobs are at risk in the coming years. A maturing economy and mercantilist geopolitical trends are accelerating this process (Chart 17). Beijing will have to confiscate wealth from the coastal provinces and power centers to reduce inequality and social grievances. Chart 16Regional Inequality In China Chart 17Large Manufacturing Sector Getting Purged Second, migrant workers are drifting home amid the COVID-19 crisis, just as in 2008. 51 million migrants vanished from employment rolls in the first quarter (Chart 18). The government’s model of household registration reform has focused not on making it easier for migrants to integrate into wealthy coastal provinces but rather on subsidizing activity in interior provinces and foisting workers back into their home provinces. This is a trigger of unrest. Will social unrest end up being politically significant? In most cases no. Beijing is prepared to quell protests and dissent – it has devoted massive resources to domestic security, even compared to its rapid military modernization (Chart 19). Chart 18Migrant Workers Cast Adrift Amid COVID-19 Chart 19‘Stability Maintenance’ Is A State Priority The Communist Party began prioritizing “social stability maintenance” across all dimensions of society in the wake of the global financial crisis in 2008. The abortive “Jasmine Revolution” in 2011, at the height of the Arab Spring, was literally swept away by street-cleaning trucks. The Wukan riots that same year were more persistent, flaring up again in 2016, but the siege was ultimately confined to a single city in the generally more restive south. Various shows of defiance in Wuhan and Hubei in the wake of COVID-19 have been snuffed out. Social unrest will not always be politically significant. State repression and mismanagement could turn any minor incident of unrest into a major incident. But as long as disturbances remain local, they will have limited political consequences. The risk for China is its pursuit of innovation and technological modernization. Greater connectivity will increase the potential for cross-border coordination. The running assumption is that China is an authoritarian state with sufficient police force to silence any discontent. But political activism does not have to be liberal – it could be nationalist, or simply based on quality of life issues that cannot easily be demonized. At any rate, the dislocation of the manufacturing sector and labor market in the context of a secular growth slowdown is a long-term tailwind for social and political challenges to the state. Political risk will grow, not fall, from here. Diversions From Domestic Unrest Beijing’s attempt to re-centralize power and reassert Communist Party control has sparked resistance in the Chinese periphery. Both Taiwan and Hong Kong have seen protest movements – consisting of middle class workers as well as youth – since 2013. These movements have not spread to the mainland – if anything they are a diversion from the mainland’s own problems. But they have prompted Beijing to crack down on the periphery, further polarizing opinion. While unrest in Hong Kong will heat up as Beijing attempts to impose even more direct control, ultimately Hong Kong has no alternative. Taiwan, on the other hand, is an island that already largely conceives of itself as an autonomous unit. The sense of Taiwanese identity – as opposed to Chinese – has exploded upward in recent years (Chart 20). There is a very high bar for war in the Taiwan Strait. And yet Chinese military hawks and strategists have begun to discuss it more openly. China’s military drills around the island are a measured but intimidating response to the rise of the popular, nominally pro-independence government since 2016. The US is making active but measured moves to shore up the diplomatic and military relationship with Taiwan. Given Washington’s renewed focus on China’s drive to achieve dominance in semiconductors, and America’s desire to secure supply chains that run through Taiwan and the mainland, we remain fully committed to our view that Taiwan is a major underrated geopolitical risk. Given the high bar for outright war on Taiwan, it should be no surprise that disputes over sovereignty and military positioning in the South China Sea should revive (Chart 21). This is a convenient outlet for Chinese nationalism. The sea is of vital strategic importance to all the major East Asian economies – not because of resources but because of supply security. Military actions in the sea have a direct bearing on cross-strait relations as well as Sino-Japanese relations, which are also liable to flare up during periods of economic distress. Chart 20Tensions In Chinese Periphery Set To Increase Chart 21South China Sea: Not Just A Distraction The US is pushing back in the seas as well, increasing the odds of a skirmish or incident. Recent reports that China will seek to establish an air defense identification zone (ADIZ) in the South China Sea have been dismissed by Taiwanese authorities, but an ADIZ is just one of many plausible scenarios that could escalate tensions overnight. Will The US Sabotage China? The US election has the potential to exacerbate China’s economic and political insecurities in the near term. The major constraint on US-China economic decoupling is well known: US allies, such as Europe and Japan, can and will continue to trade with China. Thus the US would suffer the most if it insisted on an outright blockade of trade or tech. The implication, however, is that President Trump will change strategy in any second term. There is a substantial risk to European industry that he could attempt a trade war with the EU as well as China. But the major constraint – that the US cannot take on China alone – means that his advisers across all parties and agencies will urge him to change his position. Whether he will listen is anybody’s guess. Meanwhile a Democratic victory will ensure a multilateral strategy is adopted, as was the case from 2008-16. The real political risk comes when Xi Jinping attempts to step down and pass the baton to a successor. In this regard it is essential to recognize that China’s progress up the manufacturing value chain is a threat to US allies independently of the United States (Chart 22). Chart 22China’s Manufacturing Rivals Advanced Nations Judging by China’s fastest growing export categories, Germany, South Korea, Taiwan, Japan, and Singapore have nearly as much to lose as the United States if China’s state-backed trade practices are not constrained (Chart 23). These include illegal tech transfer, hacking, and increasingly Russian-style disinformation campaigns. Chart 23US Not Alone In Concern Over China’s Manufacturing Machine Chart 24China's Rise Comes At Expense Of US Allies, Not Necessarily US In terms of overall geopolitical power, China’s rise has occurred at the expense of Japan and the EU as well as the United States, even though Europe is less threatened militarily (Chart 24). The implication is that if the US should make a concerted diplomatic effort to form a united front against China demanding verifiable reform and opening, it will eventually be able to bring its allies over to the cause. Xi Jinping’s Succession Crisis How would China respond to this external pressure, which threatens to pile onto its new domestic woes? China will resist US unilateral pressure tactics, so confrontation with a re-elected Trump could be very destabilizing. A “grand alliance” of the West that leaves open the path to economic cooperation could force China to capitulate and offer real concessions. But we are far from there today. Faced with outright confrontation or multilateral encirclement, China will double down on self-sufficiency. Thus geopolitics reinforces China’s internal political evolution and the macro backdrop outlined above. Centralization, Maoism, protectionism, and confrontation with the United States suggest that China faces serious trouble over the long run, especially when today’s massive stimulus wears off. Chart 25Markets Want Chinese Reforms And A Trade Deal Will the challenges be so great as to deprive Xi Jinping of the mandate of heaven? Not anytime soon. He sits at the helm of a wealthy authoritarian state and has the distinct advantage of having consolidated power, from 2012-17, prior to the onslaught of internal and external pressure. He enjoys popular support, despite the seeds of unrest identified in this report. The real political risk for the Communist Party comes when Xi Jinping attempts to step down and pass the baton to a successor. It was the succession after Chairman Mao Zedong’s death that occasioned the power struggles of the late 1970s. And it was Deng Xiaoping’s various attempts to set up a successor that led to unrest and party divisions in the 1980s, culminating at Tiananmen Square. The implication is that systemic regime instability is a long way off – yet still discernible. Chinese equities trade at a high risk premium. However, it may persist for some time. Political and geopolitical trends are not positive for China’s growth, productivity, private sector, or trade over the long run. Equity returns in USD terms over the course of the just-finished bull market compare very unfavorably to the previous bull market (Chart 25). On a 12-month and beyond investment horizon, we recommend investors seek cyclical and commodity plays that benefit from Chinese reflation yet are removed from its governance and geopolitical risks. These include industrial metals, Southeast Asian assets, and Japanese and European equities.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com