Emerging Markets

We are publishing the November issue of Charts That Matter. The key message from the charts on the following pages is that investor sentiment on global growth is elevated and the reflation trade is a bit overstretched. As a result, risk assets and commodities prices will likely correct, and the US dollar will rebound. Investors should keep dry powder to buy EM assets at a better entry point. A trigger for a selloff could be one or a combination of the following: the lack of a large US fiscal stimulus package, falling activity in Europe, peak stimulus in China or the recent jitter in the Chinese onshore corporate bond market. CHART OF THE WEEKThe Global Stock-To-Bond Ratio Is At A Critical Juncture The Global Stock-To-Bond Ratio Is At A Critical Juncture The Global Stock-To-Bond Ratio Is At A Critical Juncture US Equity Sentiment Is Elevated US equity sentiment is somewhat elevated and is consistent with a correction in share prices. Chart 1US Equity Sentiment Is Elevated US Equity Sentiment Is Elevated US Equity Sentiment Is Elevated Chart 2US Equity Sentiment Is Elevated US Equity Sentiment Is Elevated US Equity Sentiment Is Elevated   Peak Growth Sentiment Investors are quite optimistic on global growth. A record large net long positions in copper corroborate a very bullish investor stance on China/EM growth. From a contrarian perspective, this heralds a correction in commodities prices and EM as well as a rebound in the US dollar. Chart 3Peak Growth Sentiment Peak Growth Sentiment Peak Growth Sentiment Chart 4Peak Growth Sentiment Peak Growth Sentiment Peak Growth Sentiment   Defensive Versus Cyclical Equity Segments Defensive sectors/markets have been underperforming and are oversold. Their outperformance is likely in the near term. Chart 5Defensive Versus Cyclical Equity Segments Defensive Versus Cyclical Equity Segments Defensive Versus Cyclical Equity Segments Chart 6Defensive Versus Cyclical Equity Segments Defensive Versus Cyclical Equity Segments Defensive Versus Cyclical Equity Segments   Near-Term Risks To Industrial Metal Prices The Baltic Dry index is falling and iron ore prices have relapsed. This is consistent with diminishing Chinese imports of iron ore. However, iron ore inventories in China are not excessive, so odds are it is a correction and not a bear market in iron ore prices.  Chart 7Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices Chart 8Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices   Chart 9Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices Near-Term Risks To Industrial Metal Prices Chinese Imports Of Commodities Are At Risk From Destocking  Starting April-May, Chinese imports of copper and other commodities was running at very high rates, exceeding any reasonable estimates of final demand. This suggests China has been accumulating commodities. Even as final demand continues recovering, China might diminish imports of commodities weighing on their prices in the near term. Chart 10Chinese Imports Of Commodities Are At Risk From Destocking Chinese Imports Of Commodities Are At Risk From Destocking Chinese Imports Of Commodities Are At Risk From Destocking Chart 11Chinese Imports Of Commodities Are At Risk From Destocking Chinese Imports Of Commodities Are At Risk From Destocking Chinese Imports Of Commodities Are At Risk From Destocking   Oil Prices, Energy Stocks And Glencore Share Price Oil prices and energy stocks are facing a technical resistance. Yet, the share price of the world’s largest global commodity trader – Glencore – seems to be breaking out. The coming weeks will reveal which way the commodities complex will trade. Our bias is that a near-term correction is overdue. The US dollar holds the key, please refer to the next page. Chart 12Oil Prices, Energy Stocks And Glencore Share Price Oil Prices, Energy Stocks And Glencore Share Price Oil Prices, Energy Stocks And Glencore Share Price Chart 13Oil Prices, Energy Stocks And Glencore Share Price Oil Prices, Energy Stocks And Glencore Share Price Oil Prices, Energy Stocks And Glencore Share Price   Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound US inflation expectations – which have risen sharply since March – are likely to retreat as the US Senate does not approve a large fiscal stimulus package. Falling US inflation expectations will translate into higher TIPS yields. The latter and very bearish sentiment/positioning on the US dollar will trigger a rebound in the greenback. Chart 14Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Chart 15Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Chart 16Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound   US Elections And The US Dollar: Is 2020 The Opposite Of 2016? After the 2016 US elections, the US dollar rallied strongly for several weeks and then it sold off considerably. It seems the broad trade-weighted dollar is following a reverse pattern now.  It was selling off before the 2020 US elections and has continued weakening afterwards. If the reverse of the 2016 pattern persists, it means the US dollar is about make a major bottom and stage a playable rebound. Chart 17US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 18US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 19US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016? US Elections And The US Dollar: Is 2020 The Opposite Of 2016?   More Reasons To Expect A US Dollar Rebound The periods when US share prices outperform their global peers in local currency terms often coincide with strength in the US dollar. Recently, this relationship has broken down. The greenback might soon recouple to the upside, re-establishing this relationship (Chart 21). Besides, the broad trade-weighted dollar is very oversold (Chart 22). Chart 20More Reasons To Expect A US Dollar Rebound More Reasons To Expect A US Dollar Rebound More Reasons To Expect A US Dollar Rebound Chart 21More Reasons To Expect A US Dollar Rebound More Reasons To Expect A US Dollar Rebound More Reasons To Expect A US Dollar Rebound   Rising Real US Yields And Growth Stocks Rising US TIPS yields could create headwinds for growth stocks. FAANG and Tencent share prices have risen about 20-fold since January 2010 – as much as the Nasdaq 100 did in the 1990s before topping out. Chart 22Rising Real US Yields And Growth Stocks Rising Real US Yields And Growth Stocks Rising Real US Yields And Growth Stocks Chart 23Rising Real US Yields And Growth Stocks Rising Real US Yields And Growth Stocks Rising Real US Yields And Growth Stocks   Drivers Of EM Corporate And Sovereign Credit Spreads EM corporate and sovereign credit spreads are driven by EM exchange rates and commodities prices. A potential US dollar rebound and a correction in commodities prices warrant near-term caution on EM credit markets. Chart 24Drivers Of EM Corporate And Sovereign Credit Spreads Drivers Of EM Corporate And Sovereign Credit Spreads Drivers Of EM Corporate And Sovereign Credit Spreads Chart 25Drivers Of EM Corporate And Sovereign Credit Spreads Drivers Of EM Corporate And Sovereign Credit Spreads Drivers Of EM Corporate And Sovereign Credit Spreads Messages From Indicators And Chart Patterns Various indicators and technical chart configurations send mixed signals. Our bias is to expect a correction in risk assets in the near term.  Chart 26Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Chart 27Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns   Chart 28Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Chart 29Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns Messages From Indicators And Chart Patterns   Peak Stimulus In China Fiscal stimulus is running out. In addition, the PBoC has been tightening liquidity in the interbank market and interest rates have risen. Banks’ loan approvals have rolled over. All these point to a peak in the credit and fiscal impulse as well as money impulses in Q4 2020. Does it mean China’s economy is about to decelerate? – refer to the next page. Chart 30Peak Stimulus In China Peak Stimulus In China Peak Stimulus In China Chart 31Peak Stimulus In China Peak Stimulus In China Peak Stimulus In China Chart 32Peak Stimulus In China Peak Stimulus In China Peak Stimulus In China   China: Business Cycle Expansion To Continue In H1 2021 Our credit and fiscal spending impulse points to a continuous expansion in the Chinese economy for now. If the credit and fiscal impulse rolls over in Q4 2020, as shown in the previous page, the business cycle in China will peak around middle of 2021 given the nine-month time lag between this impulse and economic data. Chart 33China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021 Chart 35China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021 Chart 34China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021 China: Business Cycle Expansion To Continue in H1 2021   Stress In The Chinese Onshore Corporate Bond Market The recent defaults by several SOEs on their bond payments have led to a spike in corporate bond yields. However, there is no stable historical relationship between onshore corporate bond yields and the A-share market. Chart 36Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market Chart 37Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market   Chart 38Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market Stress In The Chinese Onshore Corporate Bond Market China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? During periods of rising onshore corporate bond yields, the MSCI ex-TMT Investable equity index rallied if Chinese EPS expectations where improving. The latest rollover in EPS growth expectations amid rising corporate bond yields is a warning to share prices. Chart 39China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? Chinese And EM Equity Relative Performance Versus Global Stocks China’s outperformance versus global stocks has been due to its TMT stocks (Alibaba, Tencent and Meituan). In turn, excluding Chinese stocks, EM ex-China has not really outperformed the global equity index. Chart 40Chinese And EM Equity Relative Performance Versus Global Stocks Chinese And EM Equity Relative Performance Versus Global Stocks Chinese And EM Equity Relative Performance Versus Global Stocks Chart 41Chinese And EM Equity Relative Performance Versus Global Stocks Chinese And EM Equity Relative Performance Versus Global Stocks Chinese And EM Equity Relative Performance Versus Global Stocks Various EM Equity Indexes Till very recent (before the announcement of progress in vaccines), EM small caps, the equal-weighted index, EM ex-TMT stocks and the EM index ex-China, Korea and Taiwan had been lackluster. Will the latest spike persist? It depends on the S&P500 and global risk asset performance. Chart 42Various EM Equity Indexes Various EM Equity Indexes Various EM Equity Indexes Chart 43Various EM Equity Indexes Various EM Equity Indexes Various EM Equity Indexes   Chart 44Various EM Equity Indexes Various EM Equity Indexes Various EM Equity Indexes Chart 45Various EM Equity Indexes Various EM Equity Indexes Various EM Equity Indexes   Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia’s and overall EM relative performance versus global stocks is unlikely to break out now. We continue recommending a neutral allocation to EM equities in a global equity portfolio. Chart 46Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 47Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Chart 48Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 49Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights In the first nine months of 2020, China's capital outflows, measured by the Balance of Payments (BoP) data, have been the largest since 2016. Unlike 2016, the outflows are mainly driven by a strategic accumulation of foreign currency (FX) assets by domestic entities rather than capital flight. Chinese banks may have been using some of their FX holdings and transactions to slow the pace in the RMB appreciation.  The RMB can still devalue relative to the USD in the next two months, but in the next 6-12 months, the RMB should continue to revert to its pre-trade war value. Feature Chart 1Large Capital Outflows Despite A Strong RMB Large Capital Outflows Despite A Strong RMB Large Capital Outflows Despite A Strong RMB China’s official BoP data imply that approximately $200 billion capital left the country in the first three quarters of the year, the largest amount since 20161 (Chart 1). The large capital outflows occurred when China’s post COVID-19 economic recovery was strengthening, the current account surplus was surging, and both direct and portfolio investment flows were net positive.  Moreover, unlike 2015-16 when capital outflows were driven by, and in turn, reinforced the depreciation in the Chinese currency, the RMB has been strengthening against the USD. In this report, we examine China’s BoP data and related figures, and use the framework from a previous Special Report to assess China’s capital outflows.2 Our research shows that at least a good portion of the capital outflows was likely an effort by Chinese policymakers to slow the pace of the RMB’s appreciation against a basket of its trading partners’ currencies. A Puzzling BoP Picture Official BoP data shows that China’s current account surplus was $170 billion in the first three quarters of this year, and net FDI and portfolio flows totaled at $54 billion. The surplus has been mostly offset by an estimated $155 billion of “Other Investment” outflow in the non-reserve FX account and $53 billion in Net Errors and Omissions (Table 1). Table 1China’s Balance Of Payments Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows During the 2015-16 period, large outflows were driven by reduced foreign inflows, domestic firms paying down US dollar debt, and enterprises and households moving their assets overseas.  This time, however, the outflows appear to be largely government driven and strategic FX asset accumulations, and most likely through Chinese state-owned banks and institutional investors. Chart 2FX Settlement Has Been Net Positive FX Settlement Has Been Net Positive FX Settlement Has Been Net Positive Chart 2 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks. This is drastically different from the deep contraction in the net settlement data following the RMB devaluation in August 2015. Chart 3 also highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady this year. This implies that domestic firms are not rushing to pay off their external debt as was the case in 2015/16. Chart 3Chinese Firms Are Not Rushing To Pay Off External Debt Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows Chart 4Relatively Low Level Of Illicit Capital Outflows Relatively Low Level Of Illicit Capital Outflows Relatively Low Level Of Illicit Capital Outflows Moreover, service trade deficits from outbound tourism have narrowed substantially due to international travel restrictions, which have made it difficult for Chinese residents to move capital out of the country. Additionally, the illicit capital outflows through import over-invoicing are very low (Chart 4). Hence, a large negative reading in the “Other Investment” and “Net Errors and Omission” categories implies an accumulation of FX assets by China’s banks and intuitional investors. The net FX asset accumulation by commercial banks was $117 billion in the first nine months, largely offsetting the $170 billion current account surplus in the same period. A closer examination of BoP data also shows that in June the PBoC recorded a $118 billion fund transfer from a FX asset balance sheet, which has otherwise been flat over the past five years. It is unclear where the funds have gone, but coincidently the amount matches a $118 billion outflow in the BoP’s non-reserve FX assets during the same quarter (Chart 5). China’s non-reserve FX assets3 are mostly in offshore investment and lending, which is intermediated by a small group of state-owned entities. Given that external lending through China’s banks and financial institutions has slowed in the post-COVID-19 environment, direct and portfolio investments must have been the main sources of the FX asset accumulation (Chart 6). Chart 5Unexplained FX Fund Transactions Unexplained FX Fund Transactions Unexplained FX Fund Transactions Chart 6No Sign Of Extended Loans Or Trade Credit No Sign Of Extended Loans Or Trade Credit No Sign Of Extended Loans Or Trade Credit Capital Outflows As An Exchange Rate Stabilizer The sharp rise in the trade surplus and foreign capitals into China’s bond market this year explains the upward pressure on the RMB. Chinese policymakers may have been trying to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by large state-owned banks and other financial institutions. Following the devaluation of the RMB in August 2015, China had to liquidate a quarter of its official FX reserves to defend the currency. The rapid depletion in the official reserves fueled market jitters and reinforced the RMB depreciation. The FX assets held by China’s state-owned banks and institutional investors, on the other hand, can mostly fly under the radar and, in recent years, may have become the policymakers’ preferred channel of regulating fluctuations in the currency market. We tested this theory by assessing the relationship between the net FX purchases by China’s banks and the RMB exchange rate against the USD and a basket of its trading partners’ currencies (measured by the CFETS index). The latter is the exchange rate reference regime that China switched to in 2017.4 The official “net FX settlement by bank itself” data series represents the difference between the banks’ purchases and sales of foreign exchange in the interbank system. We exclude settlements and sales by banks on behalf of clients to filter out the demand for FX from enterprises and households. Chart 7 shows that, prior to 2018, the banks’ net FX purchases ticked up when the RMB appreciated against the USD, and banks sold more FX when the USD rose against the RMB. The interventions intended to slow the market move in either direction to keep the USD/CNY exchange rate swings within the PBoC’s comfort zone. Chart 7Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Chart 8Since 2018 China Targeted A Basket Of Currencies Since 2018 China Targeted A Basket Of Currencies Since 2018 China Targeted A Basket Of Currencies Interestingly, the tight relationship loosened somewhat after 2018. On several occasions, banks made more FX purchases even when the RMB was weakening against the USD. It appears that since US tariffs on Chinese goods began in 2018, Chinese policymakers have been more willing to allow market forces drive down the RMB in relation to the USD. Meanwhile, China has targeted a relatively stable value of the RMB against a basket of its trading partners’ currencies in the CFETS index. As Chart 8 (top panel) illustrates, since 2018, net FX purchases by Chinese banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (both rebased to December 2014=100). When the RMB falls relative to the USD but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate or raise the value of other currencies in the CFETS basket (Chart 8, bottom panel). Investment Conclusions Chart 9Mean Reversion In The USD/CNY Will Continue Mean Reversion In The USD/CNY Will Continue Mean Reversion In The USD/CNY Will Continue The market sentiment has been overwhelmingly bullish on RMB. Partially, the CNY/USD market has been pricing in the possibility of a Biden administration in the US, and improved Sino-US relations. In our view, the RMB has not moved into outright expensive territory and will continue to revert to its pre-trade war value against the USD in the next 6-12 months (Chart 9). In the next two months, however, the RMB may still give back some of this year’s gains against the USD. A contested US election may bring negative surprises to the global financial markets. The COVID-19 pandemic also remains a headwind in Europe and North America until a vaccine is widely available. As such, the USD will likely have a near-term countercyclical rebound. In fact, a depreciation in the RMB would be a boon to China’s domestic economy as it currently faces disinflationary pressures. Meanwhile, the net FX settlement among Chinese banks has been trending sideways in the past three months, which signals that Chinese policymakers may be comfortable with the RMB’s current value. We think China will allow the RMB to appreciate against the USD as long as the RMB does not climb too rapidly against the basket of other major currencies. If the upward pressure on the RMB continues to push the CFETS index higher, then China may choose to step up its purchases of FX assets. Assets in Euro, the Japanese Yen, and the Korean Won may be high on the shopping list (Chart 10 and Chart 11). Chart 10China May Step Up Purchases Of Other Major Currencies China May Step Up Purchases Of Other Major Currencies China May Step Up Purchases Of Other Major Currencies Chart 11The CFETS RMB Index Composition Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows     Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1Based on the Balance Of Payments methodology, short-term capital outflows = current account surplus + changes in reserve assets + direct investment ≈ net flows in portfolio investment + net flows in other investment + net errors & omissions. 2Please see China Investment Strategy Special Report "Monitoring Chinese Capital Outflows," dated March 20, 2019, available at cis.bcaresearch.com 3FX assets held at banks and financial institutions other than the PBoC. 4CFETS RMB Index refers to CFETS (China Foreign Exchange Trade System) currency basket, including CNY versus FX currency pairs listed on CFETS. The sample currency weight is calculated by international trade weight with adjustments of re-export trade factors. The sample currency value refers to the daily CNY Central Parity Rate and CNY reference rate. Cyclical Investment Stance Equity Sector Recommendations

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar Rising US Real Yields Are Positive For The US Dollar Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Rising US Real Yields Are Negative For Growth Stocks Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July Chinese Onshore Equities Have Been In A Trading Range Since Early July Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate The US Versus Euro Area: Real Yield Differentials And Exchange Rate The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar Investors Are Downbeat On The US Dollar Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Investors Are Very Long Safe-Haven Currencies... Investors Are Very Long Safe-Haven Currencies... Chart 8...And Modestly Long Cyclical Currencies ...And Modestly Long Cyclical Currencies ...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar US Relative Equity Outperformance Heralds A Stronger US Dollar US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold The US Dollar Is Very Oversold The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies EM Stocks Do Not Outperform When The Dollar Rallies EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China EM Versus Global Equity Performance: With and Without China EM Versus Global Equity Performance: With and Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet EM Equity Index: No Breakout Yet EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations