Emerging Markets

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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 China's Rapid Growth, A Pillar Of Stability, Is Officially Gone China's Rapid Growth, A Pillar Of Stability, Is Officially Gone Table 2The Great Chinese Boom, 1980-2020 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Chinese And Global Sentiment Recovering Chinese And Global Sentiment Recovering Chart 3China's Demographic Changes Portend Higher Cost Of Capital China's Demographic Changes Portend Higher Cost Of Capital China'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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 5China Needs Growth To Service Debt China Needs Growth To Service Debt China Needs Growth To Service Debt Chart 6China Struggling To Avoid 'Twin Deficits' China Struggling To Avoid 'Twin Deficits' China 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 China Will Miss Some Centennial Income Targets China 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 Xi Jinping Was Originally Slated To Step Down In 2022 Xi 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 11SOE Bull Market Under Xi Jinping SOE Bull Market Under Xi Jinping SOE 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 13Centralization And Closed Economy Harm Productivity Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Unemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Chart 14BUnemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Unemployment Spike A Threat To Chinese Stability Chart 15Income Inequality In China Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 17Large Manufacturing Sector Getting Purged Large Manufacturing Sector Getting Purged Large 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 19‘Stability Maintenance’ Is A State Priority Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 21South China Sea: Not Just A Distraction Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? 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 Is Xi Jinping Losing The Mandate Of Heaven? Is Xi Jinping Losing The Mandate Of Heaven? Chart 24China's Rise Comes At Expense Of US Allies, Not Necessarily US China's Rise Comes At Expense Of US Allies, Not Necessarily US China'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 Markets Want Chinese Reforms And A Trade Deal Markets 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

Highlights EM QE programs will ensure that EM local currency bond yields will drop further. However, the impact of these EM QE programs on EM currencies is ambiguous. Continue receiving long-term swap rates in a number of EM economies. QE programs globally constitute public debt monetization. A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. However, DM and EM QE programs could fuel financial market manias. Feature Chart I-1Broad Money Is Booming In DM And Accelerating In EM Broad Money Is Booming In DM And Accelerating In EM Broad Money Is Booming In DM And Accelerating In EM In this report we discuss the various quantitative easing programs (QEs) that have begun to surface in emerging economies. This is a new phenomenon that will likely mark a major precedent for EM central banks. Over time, these programs will likely become more prominent tools in EM. Understanding these unorthodox monetary policy easing measures in EM and DM is of paramount importance to investors. We use a Q&A format to discuss and elaborate on this topic. Question: What has forced the authorities to launch QE programs in EM and what forms have they taken? Answer: QE programs in developing countries are in their infancy. Several governments launched them in haste in the month of March in response to the recession and panic selloff that was occurring across global financial markets. These programs will be shaped by different forces and take different forms over time. Generally, QE programs are implemented in order to: (1) halt the abrupt deleveraging among local commercial banks amid the COVID-19 crisis (2) ensure credit continues to flow to the real economy (companies and households) (3) bring down long-term interest rates and prevent large government borrowings from crowding out the private sector. In addition to slashing policy rates, many EM central banks (CBs) are implementing one or more of the following initiatives to achieve these objectives: I.  Providing unlimited liquidity to commercial banks through various facilities II.  Buying government bonds III. Conducting direct purchases of local currency corporate bonds and, in some cases, mortgage-backed securities IV. Direct lending to non-banks such as mutual funds and enterprises V. Expanding the range of public and private sector securities that can be used as collateral when lending to banks The second, third and fourth types of operations can be considered forms of QE to the extent that they fall beyond the scope of customary CB operations. The latest QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. Table I-1 provides information about various central bank policies across mainstream EM countries. Details are still limited regarding the technicalities, quantity and timelines of some of these measures. Table I-1Quantitative Easing Policies Annouced By Emerging Economies Understanding QE Programs In EM And DM Understanding QE Programs In EM And DM Question: Do these QEs represent a public debt and fiscal deficit monetization? Answer: Yes, monetary and fiscal policies are being coordinated and these QEs qualify as public debt monetization. This is also true for the QEs in advanced economies. These QE policies have been designed to ensure that the cost of government borrowing does not rise amid the surge in public sector borrowing requirements. Especially at a time when foreign investors were abandoning EM financial markets. Governments have deployed large fiscal stimulus packages to offset the devastating economic impact of COVID-19 induced shutdowns. Coupled with a collapse in fiscal revenues, this has resulted in a widening of fiscal deficits and large borrowing requirements. Chart I-2EM QEs Are Intended To Drive Down Local Bond Yields EM QEs Are Intended To Drive Down Local Bond Yields EM QEs Are Intended To Drive Down Local Bond Yields EM local currency government bond yields spiked in March (Chart I-2). This prompted CBs in many EMs to announce government bond purchasing programs in order to bring down government bond yields. Government bond yields influence other interest rates such as those for consumer and business loans. Higher borrowing costs amid a deep recession would have been lethal for corporate and household debtors. Additionally, it would have materially damaged public debt dynamics. To bring down government bond yields and ensure that policy rate cuts translate into lower borrowing costs across the entire yield curve, CBs have begun purchasing government bonds in the following developing countries: Brazil, South Africa, Poland, Colombia, India, Malaysia, Indonesia, Thailand and Korea. Government bond yields in many EMs have declined since mid-March (Chart I-2). That could be at least partially attributed to EM CBs’ QE programs. CB purchases of government bonds in either primary or secondary markets, qualify as public debt monetization. Question: How are QEs different from conventional CB operations and what makes them so unique as to warrant investor attention? Answer: There are three things that distinguish these QE initiatives from traditional CB operations: First, CBs do not typically lend to non-banks. They do not lend to or purchase credit instruments issued by non-banks. Hence, by purchasing corporate bonds and issuing loans to non-banks, CBs have entered into unchartered territory. This is also true for the Federal Reserve and CBs in other advanced economies. Second, by buying government bonds CBs are conducting an outright monetization of public debts and fiscal deficits. This is true for central banks in both EM and DM. Outside QEs, monetary authorities typically set the short-term interest rate and provide enough liquidity to the banking system to keep short-term interbank rates on par with policy rates. Chart I-3Fed’s Ownership Of Treasurys Fed's Ownership Of Treasurys Fed's Ownership Of Treasurys Prior to the launch of QE programs, CB operations with long-term government bonds were limited in scope and often technical in nature. For example, the Fed’s ownership of US Treasury securities rose by only 40% from $550 billion in 2002 to $775 billion in 2006. By comparison, it has doubled from $2 trillion to $4 trillion since September 2019 (Chart I-3). When CBs buy government bonds en masse, as they are currently doing in many countries, we are no longer talking about open market operations, but rather the monetization of public debt. Third, by launching QEs, CBs affect long-term interest rates. When financial markets are malfunctioning, which results in unjustifiably elevated long-term interest rates and cost of capital, QEs become essential to ensure the monetary policy transmission channel is operating effectively.  Nevertheless, as we have seen in the cases of the ECB and Bank of Japan, the use of QEs can become addictive. Once CBs have deployed QEs, they have a hard time abandoning them. When the financial systems and markets get accustomed to zero or negative nominal interest rates and to a constant overflow of CB liquidity, the termination of QEs will be disruptive and painful. Consequently, there is a risk that both DM and EM CBs will end up overdoing it with QEs - suppress long-term interest rates too much, for too long and for no justifiable reason. This will in turn lead to misallocations of capital, asset bubbles and other distortions in financial markets and real economies. If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise even if real output returns to its potential pace. Question: Is it fair to say that QEs lead only to an increase in commercial banks’ excess reserves at the CB, and that they have no real impact on the money supply? In other words, if commercial banks do not lend, is it true that the money supply will not expand and, thereby, QEs will never lead to higher rates of inflation?  Answer: Not really. QEs have a much more nuanced impact on the money supply. Moreover, the relationship between the money supply and the inflation rate is not straightforward. We will consider several examples, dissecting the impact of QEs on both excess reserves (ER) and the money supply. But first, let us recall that the broad money supply is the sum of both the cash in circulation and all types of deposits in commercial banks, including demand, time and savings deposits. Commercial banks’ ER at CBs are not included in either the narrow or broad definitions of money supply. Case 1: When a central bank purchases securities from or lends to a bank, ER rise although no deposit is created, so the money supply does not change.  Case 2: When a central bank purchases securities from or lends money to non-banks, this transaction creates both an ER and a new deposit in commercial banks, meaning that the money supply does increase. Case 3: When a commercial bank buys securities from or lends to non-banks, ER do not change while a new deposit is created “out of thin air”, so that the money supply rises. Conversely, when a bank sells a security to a non-bank, or a non-bank repays a loan, the money supply (i.e. the amount of deposits in the banking system) shrinks. To sum up, QEs lead to a larger money supply when CBs purchase assets from or lend to non-banks. When CBs purchase assets from banks, no new money (deposits) are created. Importantly, the money supply also expands when commercial banks buy securities from or lend to non-banks. Chart I-4A and I-4B reveal that QEs in the US, the UK, Japan and the euro area, over the past 10 or so, years have created a lot of ER but little money supply. Chart I-4AExcess Reserves Have Expanded More Than Broad Money In US, Japan… Excess Reserves Have Expanded More Than Broad Money In US, Japan... Excess Reserves Have Expanded More Than Broad Money In US, Japan... Chart I-4B… Euro Area And UK ... Euro Area And UK ... Euro Area And UK   In China, the broad money supply has been exploding since 2009. The commercial banks have, on their own, generated an enormous increase in the money supply “out of thin air”, by making loans to and buying securities from non-banks, even though there has been much less ER creation from the PBoC (Chart I-5). The top panel of Chart I-6 illustrates the remarkable evolution of broad money supply in China versus the US, the euro area and Japan. In the chart, broad money supply in these four economies is plotted along the same scale, since January 2009, when QEs began in DM and the credit boom commenced in China. Even though ERs have expanded much more in the US, the euro area and Japan (Chart I-6, bottom panel), broad money growth in China outstripped all other economies by a large margin (Chart I-6, top panel). Chart I-5Excess Reserves Have Expanded Less Than Broad Money In China Excess Reserves Have Expanded Less Than Broad Money In China Excess Reserves Have Expanded Less Than Broad Money In China Chart I-6Broad Money And Excess Reserves: China Versus DM Broad Money And Excess Reserves: China Versus DM Broad Money And Excess Reserves: China Versus DM     As we discussed in our previous reports on money, credit and savings, money supply growth is not at all contingent on savings in an economy. Rather, outside of QEs money in all countries is primarily created by the commercial banks when they lend to or purchase assets from non-banks. Still, the nature of QE is now changing in the US. Chart I-7 reveals that the broad money supply is booming faster than it ever has, since World War II. As the Fed lends directly to businesses and purchases corporate bonds that are largely held by non-banks, the money supply will explode in the US, alongside a surge in ER. Chart I-7US Money Growth: The Sky Is The Limit US Money Growth: The Sky Is The Limit US Money Growth: The Sky Is The Limit Chart I-8April Datapoints Suggest Notable EM Money Growth Acceleration April Datapoints Suggest Notable EM Money Growth Acceleration April Datapoints Suggest Notable EM Money Growth Acceleration Similar trends will occur in EM and other DM (Chart I-8): as their CBs buy securities from non-banks, they will simultaneously create both ER and new deposits at commercial banks (money supply). Question: Does this potential explosion in money supply globally – and in the US in particular – imply that there is an imminent risk of an inflation outbreak in the real economy? Answer: A stronger money supply does not in itself constitute a sufficient reason to expect a rise in inflation rates. Inflation (rising prices of goods and services) also depends on the velocity of money and the productive capacity of an economy. Nominal GDP = Velocity of Money x Money Supply In turn, Nominal GDP = Output Volume x Prices Hence, Output Volume x Prices = Velocity of Money x Money Supply Finally, Prices = (Velocity of Money x Money Supply) / Output Volume. Therefore, inflation is contingent not only on the money supply but also on the velocity of money and the output volume. The money supply will continue surging in the US and will boom in the rest of the world as other CBs also deploy QEs (Chart I-7 and I-8). However, the surge in money supply has so far been offset by a lower velocity of money (Chart I-9Aand I-9B). The velocity of money reflects the willingness of consumers and businesses to spend their money. Chart I-9AVelocity Of Money Dropped In March Velocity Of Money Dropped In March Velocity Of Money Dropped In March Chart I-9BVelocity Of Money Dropped In March Velocity Of Money Dropped In March Velocity Of Money Dropped In March If the velocity of money recovers to its pre-pandemic levels amid the massive expansion of money supply, inflation will rise. In a nutshell, money growth will be booming worldwide due to QEs but the velocity of money, or the willingness to spend, will be the critical factor in determining inflation dynamics in the months and years to come. Question: Will the current excessive creation of money leak into asset prices and produce asset bubbles? Answer: It could. As we discussed in our January report titled, A Primer On Liquidity, an abundant money supply is conducive to higher asset prices and bubbles, but it is not a sufficient condition. Investors should be willing to allocate money to financial assets in order for the latter to appreciate. For example, since the beginning of this year, global risk assets have gone through an enormous roller-coaster ride. Through mid-February, risk assets were buoyant and the oft-cited rationale for the rally was plentiful liquidity. Then, from mid-February on through late March, we witnessed historic liquidity crunches across all financial markets, including US Treasurys. It is crucial to note that neither ER in the global banking system, nor global narrow and broad money slowed down during that period (Chart I-1 on page 1 and Charts I-4A and I-4B on page 6). Investors were simply liquidating financial assets and raising their cash level. Since late March, risk assets have been rallying as investors have felt more comfortable taking on more risk. Overall, whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Just as price inflation in the real economy is dependent on the willingness of consumers and businesses to spend their money on goods and services, financial asset price appreciation is contingent on the animal spirit of all investors and their inclination to take on more risk. Whether ballooning money supply flows into financial assets or not is contingent on the willingness of all types of investors to deploy their deposits into financial markets. Question: How does the stock of US dollars (the broad money supply) compare with the value of US-denominated securities available to investors? Has the Fed’s purchases of securities not shrunk the amount of publicly-traded securities available to investors? Answer: Yes, indeed, they have. One of the distortions that the Fed’s and other CBs' QEs created has been the shrinkage of publicly-traded bonds and stocks. This has certainly lifted asset prices to levels they would have otherwise not reached. Chart I-10 plots the ratio of the US broad money supply-to-the market value of all US dollar-denominated securities. The US broad money supply represents all US dollars in the world – in cash and in electronic bank deposits. The denominator is the market capitalization of US denominated stocks and all types of bonds held by non-bank investors. It is calculated as the sum of the following: US equity market capitalization (the Wilshire 5000); the market cap values of all US-dollar bonds, including government, corporate, mortgage-backed securities, asset-backed securities and commercial mortgage backed securities (the Bloomberg Barclays US Aggregate Index); and the market cap value of US dollar-denominated bonds issued by EM governments and corporations; minus the Fed’s and US commercial banks’ holdings of all types of securities. Chart I-10The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The US: Broad Money Supply Relative To Equity And Bond Market Capitalization The higher this ratio, the more US dollar deposits, or liquidity, is available per one dollar of market value of outstanding securities – excluding those held by the Fed and US commercial banks. Based on the past 25 years, this ratio is somewhat elevated meaning that liquidity is relatively abundant. However, as argued above, animal spirits among investors are as important in driving financial asset prices as the amount of money supply. Question: What will happen to exchange rates in general, and to EM currencies in particular, given that almost every country in the world is expanding its money supply, simultaneously? Answer: There is no stable correlation between the relative money supply of two individual economies and their bi-lateral exchange rate. In addition, this is the first time that QEs are being deployed in both DM and EM countries at the same time. Therefore, there is no easy and straightforward answer to this question. Chart I-11EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? EM Currencies: A Bounce Or Beginning Of A Cyclical Rally? We recommend using the following framework to think about EM exchange rates versus the US dollar, at the moment: 1. EM currencies in aggregate will continue to be driven by global growth, as they have been historically. Chart I-11 illustrates that the EM ex-China currency index correlates with industrial commodity prices. The basis for this correlation is that they are both driven by the global business cycle. So far, the advance in both EM exchange rates and industrial commodities has been tame. It is still not clear if this is merely a rebound from very oversold levels or rather the beginning of a cyclical rally. 2. The rampant expansion of US money supply will eventually lead to the greenback’s depreciation. However, for the US dollar to depreciate against EM currencies, the following two conditions should be satisfied: US imports should expand, meaning that the US should send dollars to the rest of the world by buying goods and services. This has not yet happened though, as domestic demand in America has plunged and any demand recovery in the next three to six months will be tame and muted. US investors should channel US dollars to EM to purchase EM financial assets. 3. From an individual EM perspective, there are several scenarios to consider: If a country’s QE: materially boosts its real growth, its currency will rally in spite of ongoing domestic QE; fails to meaningfully boost growth, its exchange rate will weaken; produces a rapid rise in inflation, its currency will depreciate; is used to finance unsustainable public debt dynamics, its currency will depreciate. As we have written in the recent reports, this could very well be the case in Brazil and South Africa. Investment Conclusions We expect EM local yields to fall further. For absolute-return investors we continue to recommend receiving swap rates in Korea, China, India, Malaysia, Russia, Colombia and Mexico. Our country allocation for EM local currency bond portfolios is always presented at the end of our reports on page 15. We continue shorting a basket of the following EM currencies versus the US dollar: BRL, CLP, ZAR, PHP, IDR and KRW. However, if the strength in EM currencies persists in the near term, we will close our short positions. Continue underweighting EM equities and credit within global equity and credit portfolios, respectively. Within the EM credit space, favor sovereign to corporate credit. On that issue, please refer to our April 22, Special Report on EM foreign currency debt. For dedicated EM equity managers, we recommend overweighting Korea, Thailand, Vietnam, Russia, central Europe, Mexico and Peru. Our underweights are Indonesia, India, the Philippines, the UAE, South Africa and Brazil. Please refer to our Open Position Table on page 14. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, Next week we will be sending you a Special Report providing our insights on the much-anticipated China National People’s Congress. We think the messages sent from the conference will be highly relevant to both the global economy and financial markets. Please note: instead of Wednesday, the Special Report will be published on Thursday the 28th of May. Best regards, Jing Sima China Strategist Highlights Insert HiEarly signs suggest a renewed appetite among Chinese consumers for real assets and durable goods. China’s discretionary consumption will likely benefit greatly from pro-growth measures, and recover much faster than the aggregate consumption.   The unemployment rate has been rising and largely concentrated in lower-income workers. Elevated unemployment will be a drag on China’s overall consumption, but its impact on discretionary consumption is limited. We are initiating two trades: long investable consumer discretionary/short investable consumer staples and long domestic consumer discretionary/broad A-share market. Feature Chart 1Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Sectors Directly Benefiting From Stimulus Are Recovering Faster Economic data released last week showed that China’s economy continued to recover, particularly the infrastructure, construction and high-tech sectors (Chart 1). On the other hand, household consumption, which accounts for nearly 40% of the country’s economy, remained in a deep contraction in April. While we think the annual growth in China’s aggregate household demand will remain muted this year, the breakdown in April’s retail sales data suggests that the speed in consumer discretionary spending is already accelerating (Chart 2). During economic recoveries, consumer discretionary spending usually rebounds ahead of a recovery in overall consumption. Even though the current economic downturn is extra-ordinary, we believe that China’s discretionary consumption growth will pick up faster and stronger than the aggregate household consumption. Consumer discretionary stocks, an early cyclical sector in China’s equity market, troughed about 3 months ahead of a bottoming in Chinese investable and domestic stock prices in previous cycles. In line with our constructive view on Chinese stocks in the next 6 to 12 months, we recommend investors overweight Chinese consumer discretionary stocks relative to the benchmarks. In addition, we are initiating a long position in investable consumer discretionary versus investable consumer staples, and a long position in domestic consumer discretionary versus A-share market. Chart 2Discretionary Consumption Is Rebounding Faster Than Staples A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks China’s Stimulus-Driven Consumption Cycles Chinese consumption cycles since 2008 have mostly reflected the effectiveness of China’s pro-consumption and stimulus policies. So far, the Chinese government’s stimulus measures have been concentrated in the corporate sector rather than households. Nevertheless, government pro-growth measures, flush liquidity in the market and global travel restrictions should provide a lift to domestic sales of durable and luxury goods. Chart 3 illustrates how, in contrast to the US, China’s retail sales have grown faster than nominal GDP during every economic downturn since 2008. A reason for this counter-cyclicality in China’s consumption is that the monthly retail sales data consists of household, government and business purchases.  Since the Chinese government tends to increase its expenditures during economic downturns, the increases in government purchases help to offset the declines in household and business consumption. Chart 3Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Retail Sales In China Have Become 'Countercyclical' Since 2008 Chart 4China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus China's Post-GFC Consumption Cycles Largely Driven By Stimulus A more important contributor to the faster retail sales growth during economic down cycles is government stimulus. Direct pro-consumption policies, such as sales tax cuts and subsidies, helped to boost auto sales in every cycle since 2008, whereas stimulus measures to enhance home sales indirectly led to an upcycle in the sales of home appliances in 2015-2016 (Chart 4).  April’s retail sales data showed a sharp rebound in Chinese household consumption in autos, appliances and furniture (Chart 5). The strong comeback in durable goods purchases in April was driven by a release of pent-up demand and government pro-consumption measures. Since March, local governments have handed out subsidies, vouchers and tax reductions on consumer durable goods purchases and discretionary spending, such as travel and restaurant dining. By end-April, an estimate of 40 billion yuan worth of consumption vouchers were issued by provincial and city-level governments, with more than 90 percent of them targeted at discretionary goods and services. We think the government will announce further policies to support consumption at the May 22-23 National People’s Congress.  Chart 5A Strong Comeback In Durable Goods Sales A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chinese consumers took on more medium- and long-term loans in March and April, indicating a renewed appetite for purchasing real assets and durable goods (Chart 6). This is partially because consumers want to take advantage of lower interest rates and easier monetary conditions. Moreover, Chinese households may also be seeking real assets to hedge future inflation and financial market uncertainties. Housing in China in the past two decades has been perceived as countercyclical and a low-risk asset that holds value. Early signs indicate a renewed Chinese consumers’ appetite for real assets and durable goods. Both land sales and real estate investment growth returned to positive territory in April, while the contraction in floor space started, completed, and sold all narrowed. The upward cycle in the property market should continue to support a recovery in household appliances and furniture (Chart 7).   Chart 6Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Appetite For Real Asset Purchases May Be Returning Chart 7A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales A Recovering Property Market Should Help Boost Home Appliance Sales In addition, global travel restrictions will likely remain in place through this year. This may prompt Chinese consumers to allocate a larger portion of their discretionary spending budgets to domestic, high-end consumer goods and services. Bottom Line: Early signs indicate a renewed consumer appetite for real assets and durable goods. The government’s pro-consumption and pro-growth measures should further boost discretionary spending. The Wealth Effect The consumption behavior of Chinese households will likely be driven by both the change in the value of their assets, and their expectations of the immediate or perceived future loss of employment and income. Housing is the largest part of Chinese households’ net worth.1 At the same time, financial assets account for a much lower share of Chinese households’ net worth versus their American peers.2 Home prices are much less volatile than stock prices, and we expect home prices in China to grow faster this year than in 2019. Hence the wealth effect of housing on Chinese consumers should remain positive. The unemployment rate has been elevated, but job losses so far are concentrated in the labor-intensive, lower-skilled manufacturing and service sectors (Chart 8). While lower-income workers account for more than half of China’s total population, their share of the country’s total household wealth and income is dismal compared with households in the top 10 percentile earnings3  (Chart 9). In fact, households in the bottom 40 percentile essentially have no discretionary spending capacity.4 Households in the top 40 group (middle- and upper middle-class urbanites) are the main driver of China’s discretionary and luxury goods market.5 Chart 8Job Losses So Far Concentrated In Lower-Skilled, Lower-Wage Manufacturing & Service Sectors A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Chart 9Higher-Income Chinese Households Will Drive Recovery In Discretionary Consumption A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks Because poorer households tend to have a higher marginal propensity to consume than the richer ones, China’s high income inequality may reduce the aggregate demand and has the potential to structurally stagnate its household consumption growth. This is a topic we hope to provide insights on in our future research. Cyclically, however, accommodative monetary conditions and outsized stimulus during economic downturns often help augment richer households’ net worth as well as increase their discretionary purchasing power. Our constructive view on China’s discretionary consumption could change if a second wave of Covid-19 infections is virulent enough to trigger another round of global lockdowns. In this case unemployment may expand from lower-income to middle-class Chinese consumers and extend from temporary to permanent job losses.  Consumption will also be constrained by more widespread income declines and renewed physical lockdowns.  Bottom Line: Job losses are concentrated in the lower-income household group so far. While developments in the pandemic remain fluid, our baseline view suggests that the wealth effect will have a limited impact on Chinese middle-class consumers. Investment Conclusions The recovery is still in its early stages, but government stimulus is bearing fruit in discretionary consumption. Furthermore, the elevated unemployment rate should prompt the government to roll out more consumption and growth-supporting measures at this week’s NPC conference, which will help further boost Chinese consumers’ appetite for discretionary spending.  China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries. China’s investable consumer discretionary sector has consistently outperformed both the broad market and consumer staples during previous economic recoveries (Chart 10). The overwhelming shares of China’s online tech titans in the investable market, such as Alibaba and JD, make a strong case to overweight the consumer discretionary sector given that both online platforms will continue to benefit from the Chinese government’s pro-consumption schemes. On the other hand, the behavior of consumer discretionary versus consumer staples in China’s A-share market has been atypical.  Chart 11 shows domestic consumer discretionary stocks have consistently underperformed consumer staples since 2015, even during the 2016/2017 upcycle in broad market stock prices. We think a few underlying factors may be at play: Chart 10The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... The CD Sector Has Consistently Outperformed CS In Offshore Market Upcycles... Chart 11...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market ...It Is Not The Case In The Onshore Market Food and beverage companies in mainland China have one of the highest ROAs and the lowest financial leverages, which is preferred by Chinese domestic investors; Chinese liquor brands such as Kweichow Moutai and Wuliangye, which are listed on the A-share market and within the consumer staples group, have become collectable luxury goods. They have helped driving up the prices of consumer staple equities (Chart 12);  Soaring food prices since 2017 have helped to widen profit margins among food processing firms (Chart 13).   Chart 12Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Some 'Consumer Staples' Have Become Luxury Goods Chart 13Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor Soaring Food Prices Also A Contributing Factor For investors with a time horizon longer than a 12 months, consumer discretionary sector is a winner. However, for investors with a time horizon longer than 12 months, average returns in consumer discretionary stocks still beat staples in the past three market recoveries (Table 1). This is true for both onshore and offshore markets. As such, we recommend investors go long on consumer discretionary versus consumer staples in the investable market, and also go long on domestic consumer discretionary versus the broad domestic market. We are initiating these two trades today. Table 1CD Sector Still A Winner On A 12-18 Month Horizon A Consumption Recovery On Two Tracks A Consumption Recovery On Two Tracks   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Housing accounts for 59.1% in Chinese households’ net worth, compared with 30% in the US. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 220.4% of Chinese households’ total net worth is in financial assets. In the US, the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey”. 3China’s low-income households account for about 60% of China’s population as of 2015. “How well-off is China’s middle class?” Center For Strategy & International Studies. https://chinapower.csis.org/china-middle-class/ 4 “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 5China Consumer Report 2020, McKinsey & Company, December 2019 Cyclical Investment Stance Equity Sector Recommendations

Feature Analysis on Korea & South Africa are available on pages 6 and 10, respectively. Mexico: Balancing Pros And Cons We have been overweight Mexican sovereign credit and local currency bonds as well as equities relative to the respective EM benchmarks. Our rationale for this stance has been the fact that Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. However, the COVID-19 outbreak has introduced new dimensions into this analysis. On one hand, there are a number of positives that still warrant a lower macro risk premium on Mexican assets: The nation’s public debt burden is rising sharply but is not yet at an unsustainable level. We estimate that assuming (1) a nominal GDP contraction of 7% in 2020, (2) an overall fiscal deficit of 4.7% of GDP this year, and (3) the peso’s exchange rate versus the US dollar at 26, the gross public debt-to-GDP ratio will rise to 49% from 37% currently (Table I-1). If we assume the government takes over all SOE debt, including that of Pemex, total gross public debt will rise to 62% of GDP (Table I-1). While non-trivial, Mexico’s public debt burden is considerably lower than those in large EM countries like Brazil and South Africa. Table I-1Mexico's Public Debt Burden Mexico, Korea & South Africa Mexico, Korea & South Africa Chart I-1Mexico: Real And Nominal Rates Are Too High Mexico: Real And Nominal Rates Are Too High Mexico: Real And Nominal Rates Are Too High Despite widespread investor concerns, President AMLO has been running a very tight fiscal policy. At the end of 2019, the government had a primary surplus of 1% of GDP, and the overall deficit stood at 1.6%. In fact, given AMLO’s ideological approach to fiscal frugality, his government’s fiscal response to the COVID-19 pandemic to date has actually been less than what it can or should be. Similarly, monetary policy has been very tight. This is positive for creditors but negative for growth. The central bank has erred on the hawkish side and has a lot of room to reduce interest rates. Nominal and real interest rates in Mexico are among the highest in the EM universe (Chart I-1). Very tight fiscal policy means that monetary policy can be relaxed considerably. Interest rates in Mexico have a lot of downside.   Finally, the peso is reasonably cheap, according to the real effective exchange rate based on CPI and PPI measures (Chart I-2). Mexico’s macro risk premium relative to other EMs has been, in our opinion, wider than it should have been. On the other hand, there are considerable negatives, especially regarding the growth outlook: A year and a half into his mandate, president AMLO has not been able to secure the corporate sector’s confidence in his administration’s policies. The government was attempting to reverse this trend in the months leading up to the COVID-19 outbreak by announcing a public-private infrastructure package and improving relations with the US. Nevertheless, the decision to shun large corporations from the national fiscal response has once again weighed on business confidence. This will further reduce capital spending and hiring, prolonging the recession (Chart I-3). Chart I-2The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap Chart I-3Business Confidence Plummets Again Business Confidence Plummets Again Business Confidence Plummets Again   The government’s fiscal response to the COVID-19 pandemic has been insufficient. The central government announced measures to increase funding for social and infrastructure programs and loans for households as well as small and medium businesses, amounting to a mere 3% of GDP. This is one of the lowest stimulus packages among major economies worldwide (Chart I-4). Chart I-4Mexico's Fiscal Response Is Poor Mexico, Korea & South Africa Mexico, Korea & South Africa Mexico is highly levered to the US economy. A deep contraction in American demand for consumer discretionary goods and international travel will suffocate Mexico’s export revenues. Exports of automobiles and tourism revenues together account for 37% of total goods and services exports, and 13% of GDP (Chart I-5). Balancing pros and cons, we recommend the following strategy for Mexican markets: Continue to overweight local currency bonds and sovereign credit within their respective EM benchmarks (Chart I-6). Orthodox fiscal and monetary policies warrant an overweight stance on fixed-income plays. Chart I-5Autos And Tourism Revenues Are Significant Autos And Tourism Revenues Are Significant Autos And Tourism Revenues Are Significant Chart I-6Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit   We reiterate our trade to receive Mexican 10-year swap rates. The only reason we are reluctant to be long cash domestic bonds is the potential for further currency depreciation. Finally, we are maintaining an overweight stance on equities, even though we acknowledge the very bad profit outlook. However, historically whenever Mexican interest rates have fallen relative to EM, Mexican stocks have typically outperformed the EM equity benchmark (Chart I-7). This is the primary rationale behind our equity overweight stance. Chart I-7Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices Mexico vs. EM: Government Bond Yields Are Inversely Correlated To Stock Prices   Juan Egaña Research Associate juane@bcaresearch.com   South Korea: Bonds Offer Value Amid Looming Deflation The South Korean economy is facing strong deflationary pressures, requiring significant and additional rate cuts. Meanwhile, 10-year government bonds yield are still at 1.4%, 75 basis points over 10-year US Treasurys (Chart II-1). Hence, Korea’s bond yields offer good value for fixed-income investors and have considerable downside. We have been receiving 10-year swap rates in Korea since 2011 and are reiterating this recommendation: Chart II-2 shows that the GDP deflator has been negative since 2018, and core and trimmed mean consumer prices are flirting with deflation. Chart II-1Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Korean Government Bonds Yields: More Room To Fall Chart II-2The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation The Korean Economy Is Flirting With Deflation   Falling prices amid elevated corporate and household debt levels – at 102% and 96% of GDP respectively – is toxic. The basis is price deflation increases real debt burdens. Notably, the debt service ratio for businesses and households is very high at 19.9% of GDP. There is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Exports – which account for some 40% of GDP – are plunging. The business survey from Bank of Korea suggests exporters’ business sentiment plunged by a record in May and is close to 2008 levels, pointing to a dreadful export outlook. (Chart II-3) Domestic demand will remain weak, despite the large fiscal response to the COVID-19 outbreak. Business investment and hiring will be depressed for a while, undercutting consumer spending (Chart II-4). Chart II-3Exports In Freefall Exports In Freefall Exports In Freefall Chart II-4Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook Less Investment Plan And Poor Employment Outlook Chart II-5Falling Residential Construction Permits Falling Residential Construction Permits Falling Residential Construction Permits Finally, residential investment was in the doldrums even before the COVID-19 outbreak. Chart II-5 illustrates that declining residential construction permits preclude lower residential construction for the rest of the year. The Bank of Korea will have to cut interest rates considerably this year. From a big-picture perspective, there is no reason why Korea’s policy rate should not be reduced close to zero as is the case in advanced economies. Korea’s economy shares many similarities with advanced economies like high debt levels and persistent deflationary pressures. On top of this, Korea is much more exposed to global trade, which makes its cyclical outlook worse, heralding substantial monetary easing. Exchange Rate Low interest rates could undermine the Korean won, even though the exchange rate has not historically been driven by interest rate differentials. The key driver of the won – shrinking global trade volumes and deflating tradable goods prices – warrants a cheaper currency to mitigate the negative impact on corporate profitability (Chart II-6). Chart II-6Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation Deflating Export Prices Herald Currency Depreciation Chart II-7Deflating Semiconductor Prices... Deflating Semiconductor Prices... Deflating Semiconductor Prices...   Besides, deflation in DRAM prices (Chart II-7) as well as DRAM sales point to further currency depreciation and lower Korean tech stock prices (Chart II-8). Chart II-8...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Semiconductor Prices Are Still Deflating ...Does Not Bode Well For Tech Stocks Overall, a weak currency is needed to alleviate deflationary pressures currently present in the economy. Stocks We are negative on the KOSPI in absolute terms but continue to recommend that EM-dedicated equity portfolio investors overweight this bourse. Despite being a highly cyclical market, we believe the KOSPI’s outperformance will be due to its large weight in tech stocks. The latter will benefit from China’s ambitious tech-related infrastructure plan in the coming years. The plan includes construction of Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet and data centers. We expect total investment will reach between US$182 billion and $266 billion by the end of 2020, an increase of 30-50% over last year. Importantly, 40% of Korea’s semiconductor exports are purchased by China. We have been playing the semiconductor theme via Korea rather than Taiwan because the latter is a wild card amid escalating geopolitical tensions between the US and China. Our geopolitical team expects a flare up in US-China tensions ahead of US elections this year, and Taiwan could become one of the focal points. Bottom Line: Continue receiving 10-year swap rates, shorting the won against the US dollar and overweighting the KOSPI within an EM dedicated equity portfolio. Lin Xiang, CFA Research Analyst linx@bcaresearch.com South Africa: A Point Of No Return On Public Debt South Africa’s public debt is bound to surge to unsustainable levels: from 62% of GDP in 2019 to 95% of GDP by the end of 2021. If the government is forced to take over unsustainable debt from state-owned enterprises, which is very likely, it will push up the public debt-to-GDP ratio further by another nine percentage points to 104% of GDP. Table III-1 summarizes South Africa’s public debt projections using the following parameters and assumptions: To fight the COVID-19-induced economic crunch, President Cyril Ramaphosa recently announced a fiscal stimulus package of $26 billion (R500 billion), or 10% of GDP. Using recent government and central bank projections for 2020 and 2021, nominal GDP growth is expected to contract by 2.5% and expand 6.7%, respectively. Notably, fiscal revenue growth is expected to fall by 32% in nominal terms, according to recent comments by the Minister of Finance.1  Meanwhile, government spending will grow by 15%,2 and the primary fiscal deficit is expected to widen to 15.4% of GDP in 2020. Given that government forecasts often tend to be optimistic, chances are that both the primary deficit and public debt-to-GDP ratio will overshoot these forecasts. Finally, the sharp drop in domestic demand will increase the odds of a default among state-owned enterprises, with Eskom likely being a case in point. Current government guidelines require at least two thirds of Eskom’s R450 billion debt to be transferred to government balances in the event of default or anticipated default. In such a case, this increases the government debt-to-GDP ratio by an additional R350 billion, or 7% of GDP. Table III-1Projections For South Africa Fiscal Position And Public Debt Mexico, Korea & South Africa Mexico, Korea & South Africa Altogether, the public debt-to-GDP ratio will surge to 104% of GDP by the end of 2021 (Chart III-1). With public debt above 100% of GDP, interest rates well above nominal GDP and the government running large primary deficits, debt dynamics will become unsustainable. To avoid a public debt crisis, the government should either run large primary surpluses, which is unfeasible anytime soon, or bring down government borrowing costs to push up nominal GDP above interest rates (Chart III-2). Chart III-1Public Debt-To-GDP Will Balloon To 104%! Public Debt-To-GDP Will Balloon To 104%! Public Debt-To-GDP Will Balloon To 104%! Chart III-2Unsustainable Gap Between Local Yields And Nominal Growth Unsustainable Gap Between Local Yields And Nominal Growth Unsustainable Gap Between Local Yields And Nominal Growth   The latter option is the only one that is politically feasible. But to do so, the central bank needs to resort to the monetization of public debt. The central bank (SARB) has already taken the first step to bring down bond yields by buying government bonds in the secondary market. While the rationale of that was to cover foreign investors’ selling of local currency bonds, it amounts to nothing else but quantitative easing, or public debt monetization. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. As such, debt monetization is a fait accompli in South Africa. Monetizing part of the government’s debt will help reduce real borrowing costs and at the same time reflate nominal GDP growth, thereby boosting government revenues. Ultimately, the outcome of large fiscal deficits and public debt monetization is a weaker currency. If foreigners continue to sell the local currency bond market, the SARB and commercial banks will need to buy more government debt, creating even more money. This is why we expect the rand to continue depreciating. Investment Recommendations Chart III-3The Rand Could Drop Further Given Public Debt Dynamics The Rand Could Drop Further Given Public Debt Dynamics The Rand Could Drop Further Given Public Debt Dynamics The currency will likely get cheaper provided the rising odds of outright public debt monetization (Chart III-3). Continue shorting the rand versus the US dollar. We are initiating a new position of receiving 2-year swap rates. Odds are that the central bank will cut rates further in the months to come. Remain underweight local currency bonds in an EM-dedicated portfolio. Even though local domestic rates will likely fall, South African bonds will not outperform the EM benchmark on a total return in US dollar basis, mostly due to chronic currency depreciation. Finally, investors should underweight sovereign credit (government US dollar bonds) due to the unsustainable public debt dynamics. Dedicated EM equity portfolio investors should maintain a below-benchmark allocation to this bourse. Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     The Minister of Finance made remarks about tax revenue falling by 32% in nominal terms. Tax revenues represent almost 100% of overall revenue. 2     Overall fiscal package is estimated to be 3% of GDP. This excludes reprioritization in 2020 around R130 billion & loan guarantee scheme of R200 billion. Overall total additional spending amounts to R170 billion in 2020 fiscal year. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Even though EM equities appear cheap, the key near-term threats to them are their poor fundamentals and a renewed sell off in the S&P 500. Given the immense uncertainty, the current equity risk premium (ERP) should be at the upper end of its historical range. Hence, the discount rate – the sum of the risk-free rate and the ERP – should be reasonably high. This makes US equity valuations rather expensive. The key risk to our defensive strategy is that the rally in global growth stocks evolves into a full-fledged mania. Feature Every investor is aware that global corporate profits have collapsed due to nationwide lockdowns and profits will eventually recover as the lockdowns are gradually eased. This thesis, though, is not helpful for equity investors. To price equities properly, investors need to know how low corporate profits will fall and how fast and strong the eventual recovery will be.  Currently, visibility on the magnitude and speed of the decline in profits and the subsequent recovery is factually nil. In fact, very few companies are providing any guidance. There is enormous uncertainty surrounding the pace at which economies will be reopened, the possibility of secondary infection outbreaks and the discovery of a remedy or a vaccine for this virus. Besides, it is hard to forecast how fast animal spirits will revive among consumers and businesses worldwide. Thus, it is impossible to reliably forecast the magnitude and pace of both the decline in corporate profits and the subsequent recovery. What framework should investors use to value stocks when facing extremely low visibility? The CAPE Ratio Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. This is a structural valuation measure that looks beyond the profit cycle, i.e., removes the cyclicality of earnings per share (EPS) from P/E ratio calculations. When the profit outlook is as muddy as it is today and the possible range of outcomes is very wide, it is safe to assume that in the next 12-18 months corporate profits will revert to their historical trend, i.e., drop below and then recover to their structural trend. This is a better conjecture than any attempt to forecast the magnitude and speed of both the profit plunge and subsequent recovery. Hence, the appropriate question for investors at this time is: what is the forward P/E multiple on equities assuming that EPS will plummet and then recover to their historical trend over the next 12 to 18 months? The CAPE model provides the answer to this question. Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. Chart I-1 illustrates our EM CAPE model, showing EM equities as cheap as they were at previous major bear market bottoms. The EM CAPE is presently 12.5 assuming EM EPS plunge further in the coming months but recover to their long-run trend in 12-18 months from now (Chart I-1, bottom panel). Our measure for US CAPE presently stands in high 20s, well above its historical average of 18 (Chart I-2). Chart I-1EM Equity Valuations Are Low EM Equity Valuations Are Low EM Equity Valuations Are Low Chart I-2US Equity Valuations Are Expensive US Equity Valuations Are Expensive US Equity Valuations Are Expensive   Box I-1 on page 3 elaborates how our CAPE model is built and how it differs from Shiller’s CAPE ratio. Even though EM equities are very cheap, the key near-term threats to them are two-fold: (1) EM fundamentals remain downbeat, which is creating a near-term risk to share prices; and (2) a renewed sell off in the S&P 500 would drag EM stocks lower, despite cheap EM equity valuations. In the next section, we explore US equity valuations in a bit more detail. BOX I-1 Our CAPE Versus The Shiller CAPE: Differences In Methodologies Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data only goes back to 1986. If we were to calculate a 10-year moving average for EM EPS, we would lose 10 years of data, and the valuation indicator would only start in 1996. This is too short a time-frame for a structural valuation indicator. Chart I-3Comparing Two CAPE Methodologies Comparing Two CAPE Methodologies Comparing Two CAPE Methodologies Instead, we used the following methodology to construct the CAPE ratio for EM: We deflated EM EPS and EM equity prices (both in US dollar terms) by US consumer price inflation to get EM EPS and EM share prices in real (inflation-adjusted) US dollar terms. Then we ran a regression of EM EPS in real US dollar terms against a time trend. The resulting trend line represents the cyclically adjusted or structural EPS in real US dollar terms (Chart I-1, bottom panel on page 1). Finally, we divided EM stock prices in real US dollar terms by the cyclically-adjusted real US dollar EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-1, top panel on page 1). To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the US stock market and compared it with the Shiller CAPE ratio. Chart I-3 illustrates that our methodology generated a CAPE ratio that is similar to Shiller’s CAPE ratio. We are therefore confident that the results generated by our CAPE methodology are robust and sensible. Low Visibility = High Equity Risk Premium Chart I-4CAPE Ratio Negatively Correlates With Corporate Bond Yields CAPE Ratio Negatively Correlates With Corporate Bond Yields CAPE Ratio Negatively Correlates With Corporate Bond Yields It is a well-known fact that US equity multiples are very high. However, a common narrative in the investment community often justifies currently high US equity multiples by very low interest rates. One consideration that is missing in this argument is the equity risk premium. The P/E ratio is negatively correlated to the discount rate.1 The discount rate is the sum of the risk-free rate and the equity risk premium (ERP). Chart I-4 demonstrates that US CAPE ratio has been inversely correlated with corporate bond (BAA) yields. The latter includes both risk-free government bond yields and corporate credit spreads. Presently, one should use an ERP that is materially higher than its historical mean. Investors are currently facing record high uncertainty related to the business cycle as well as the structural trends in economic, political and geopolitical spheres. In short, enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. Critically, ERP is not a static variable. Yet, many equity valuation models assume that the ERP is constant and, therefore, compare equity multiples with risk-free rates. Such models are wrong-headed because a change in the ERP can in itself cause large fluctuations in share prices. Chart I-5Estimated US Equity Risk Premium Estimated US Equity Risk Premium Estimated US Equity Risk Premium Going forward, visibility on both the evolution of the virus containment measures and the global business cycle will eventually improve and, thereby, decrease ERPs that investors require. This will produce a lower discount rate heralding higher equity multiples. As of today, however, the tremendous uncertainty about the outlook still warrants a higher ERP. Chart I-5 illustrates that the US ERP based on our CAPE model is presently 270 basis points. It is elevated but still below historic peaks recorded in 2008 and 2011. Provided we face extremely limited visibility about the global outlook, we contend that the US ERP will likely rise in the short run. The latter will depress US equity valuations and prices. Bottom Line: Given the immense ambiguities investors are facing in regard to the business cycle and to economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. We conclude that US equity valuations are rather expensive despite the very low risk-free rate. Falling US stocks will drag EM share prices lower.  EM Versus The S&P 500: Three Conditions For A Reversal Chart I-6Relative CAPE Ratio: EM Versus US Relative CAPE Ratio: EM Versus US Relative CAPE Ratio: EM Versus US The relative EM versus US CAPE ratio is shown on Chart I-6. According to it, EM equities relative to their US counterparts are as cheap as they were at their previous major bottom in 2001. Nevertheless, valuation is not a good timing tool. For EM to start outperforming the S&P 500, three conditions are required: 1. China’s economy should embark on a cyclical recovery that is greater than the natural snapback in activity that it has been experiencing in the wake of the end of its lockdown. So far, the mainland economy is still in a snapback phase rather than in an expansion mode. 2. Global equity sector leadership should rotate from growth to value stocks, such as resource-related and banks. This has not occurred yet. The EM equity index is more sensitive to the performance of financials than the S&P 500 is. Table I-1 and I-2 represents individual EM and US sector weights in terms of both market cap and total corporate earnings in their respective equity benchmark. Financials account for 36.6% of EM total earnings and 20.9% of EM market cap. The same ratios for US financials in America’s broad equity index are 22.2% for earnings and 10.5% for the market cap. Table I-1EM Equity Sector Earnings And Market Cap Weights Equity Valuations Amid Low Visibility Equity Valuations Amid Low Visibility Table I-2US Equity Sector Earnings And Market Cap Weights Equity Valuations Amid Low Visibility Equity Valuations Amid Low Visibility   Further, EM equity prices remain highly correlated to global materials stocks (Chart I-7). As we discussed in our October 10, 2019 report, the rationale is as follows: both industrial metal prices and EM equities are driven primarily by China. Enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. 3. The US dollar should enter an extended bear market. The greenback has been resilient despite the Federal Reserve’s outright debt monetization and the general risk-on mood in global equity and credit markets. Further, the EM ex-China currency index has failed to rebound despite the noteworthy rally in the S&P 500 since late March (Chart I-8). Chart I-7EM Stocks Correlate With Global Materials EM Stocks Correlate With Global Materials EM Stocks Correlate With Global Materials Chart I-8EM Currencies Have Failed To Rally EM Currencies Have Failed To Rally EM Currencies Have Failed To Rally   For the greenback to depreciate, US dollars should be recycled overseas via augmented US imports or capital outflows from the US. It seems that none of this is currently taking place. The dollar is probably experiencing the last leg of its structural bull market that commenced in 2011. In financial markets, the final phase of a structural trend can last longer and run further than many investors expect. Odds are that the greenback will overshoot before topping out. Chart I-9 presents the real effective exchange rate for the US dollar, the euro and the Japanese yen, based on unit labor costs. This is our favored currency valuation measure. It reveals that the greenback is already expensive, but that its valuation can become even more expensive and reach two standard deviations above fair value before the US dollar peaks. In turn, according to the same measure, valuations of commodity currencies like NZD, AUD and CAD have downshifted considerably (Chart I-10). Nevertheless, they are not yet very cheap. Therefore, further undershoots cannot be ruled out. Chart I-9G3 Currency Valuations G3 Currency Valuations G3 Currency Valuations Chart I-10Commodity Currencies Valuations Commodity Currencies Valuations Commodity Currencies Valuations   Bottom Line: The conditions for EM stocks to begin outperforming the S&P 500 have not yet been satisfied. EM outperformance is not imminent. The Key Risk The key risk to our strategy of not chasing the recent equity rebound is as follows: The rally in expensive global growth stocks could evolve into a full-fledged mania. The latter would then lift the broader equity index, including value stocks. The average retail investor in any corner of the world can now make the case for an exponential rise in growth stocks: major central banks are printing money, risk-free interest rates are at zero, businesses in “new economy” are relatively immune to COVID shutdowns and, moreover, they represent the future. All conditions for a bubble formation are present: a concept that captures the average person’s imagination, good fundamentals and solid past performance, as well as liquidity overflow.  Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook. The only problem with this thesis is that these stocks have already rallied massively over the past decade and are consequently expensive and over-owned (Chart I-11). Chart I-11Each Decade Had A Mania Each Decade Had A Mania Each Decade Had A Mania Can they still go higher, dragging up overall equity indexes? They can, as the human imagination has no limits. If retail investors continue piling up on stocks – and there is some evidence they have been doing so – share prices will rise despite the expensive valuation of growth companies and the disastrous profit outlook for value stocks. Like any bubble, this mania, if it occurs, will eventually culminate with a crash. Investment Conclusions Chart I-12Growth And Value Stocks Growth And Value Stocks Growth And Value Stocks EM equities have become cheap and oversold, which is why we closed our short position in EM stocks on March 19. Nevertheless, we have not yet recommended buying or overweighting EM stocks. The near-term outlook remains risky and EM valuations could remain depressed for a while given that investors currently face zero visibility. Consistently, the risk-reward of global and EM equities is yet not attractive. The basis is as follows: Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook (Chart I-12).  For now, we continue recommending underweighting EM versus DM equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnote 1   The P/E ratio inversely correlates to the discount rate: P/E ratio = (Payout rate x (1 + Growth rate)) / (Discount rate – Growth rate)