Equities

Our long-held view has been that profit margins really only mean revert during recessions. This cycle has proved no different and empirical evidence shows that SPX margins fell over 200bps from peak-to-trough (top panel). Now that the recession is disappearing in the rear view mirror, a margin expansion phase looms. Not only are sell-side analysts’ forward margin expectations in a V-shaped recovery (top panel), but also our very own profit margin proxy (corporate pricing power growth / nonfarm payroll growth, middle panel) signals that margins will widen significantly next year. Take DIS for example. This consumer discretionary stock has vaulted to all-time highs, but DIS's cost structure is a lot leaner because of the pandemic. In other words, CEOs have adjusted cost structures to new lower run rates and investors are hoping profits will also make a comeback. Moreover, national accounts data corroborate our margin proxy message and point to a brightening margin and thus profit backdrop for 2021. Up to very recently, labor productivity was moribund, but it has now shot through the moon to the highest growth rate since the GFC (bottom panel). Bottom Line: A profit margin expansion phase is looming. We remain cyclically and structurally bullish on the prospects of the broad equity market. ​​​​​​​

Highlights Every year we review our best and worst calls – both in terms of geopolitics and markets. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. We correctly forecast the presidency, Senate, Democratic nomination, and impeachment outcome. We anticipated “stimulus hiccups” but expected them to be resolved by November 3. The Georgia runoff on January 5 presents a 30% risk to our Senate prediction. In the main, we were right on Chinese politics, EU politics, US-Iran tensions, and Russian politics. US-China tensions kept rising, as expected, but the market ignored it. We missed the Saudi-Russia cartel break-up in Q1. The jury is still out on Brexit. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. Stay long cyber-security stocks in general, but close the pair trade versus Big Tech. Close the 10-year Treasury hedge. Feature Chart 1The Black Swan The COVID-19 pandemic took investors by surprise, defined the year 2020, and caused the shortest bear market in history, lasting 33 days (Chart 1). On the whole this year’s crisis illustrates how geopolitical analysis is not primarily concerned with “black swan” events, which are inherently unpredictable. Rather the wholly unexpected pandemic reinforced several of our pre-existing geopolitical themes and trends: de-globalization, American sociopolitical instability, European integration, and US-China conflict. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. Whether these and other trends will continue in 2021 will be the subject of our strategic outlook due next week. This week we offer our annual report card, which reviews our best and worst calls for the year with a desire to hold ourselves accountable to clients, learn investment lessons from mistakes, and hone our geopolitical method of analysis. Successful Strategy, Debatable Tactics Overall our performance this year was good. Specifically, our political forecasting was on target and our investment recommendations got the big moves correct. But our risk-averse tactical trades were less successful. In last year’s annual outlook, “2020 Key Views: The Anarchic Society,” our main investment recommendation was long gold – based on sky-high geopolitical risk and a shift toward reflationary policy by the Federal Reserve, China, and the European Union (Chart 2). We maintain this trade today, despite its losing some altitude recently, as we expect to see low real rates, reflationary global policy, and rising inflation expectations. Geopolitical risk will also remain elevated despite dropping off from recent peaks, and not only during President Trump’s “lame duck” final days in office. We sounded the alarm for clients in our January 24 report, “Market Hurdles: From Sanders To Iran,” warning that global equities and risk appetite would suffer “in the very near term” due to conventional political risks as well as the new coronavirus, which we feared would explode as a result of Chinese New Year. In retrospect we were not bearish enough even in these reports. In our March 27 report, “No Depression,” we advised that the extraordinary monetary and fiscal response to the crisis would reflate the global economy and thus went long Brent crude oil. From this point onward we gradually added risk to our strategic portfolio, including by going long global equities relative to bonds in June (Chart 3). Chart 2Gold Paid Off When Black Swan Arose Of course, despite getting these big moves right, we abandoned several of our strategic recommendations during the crisis and some of our tactical trades went awry throughout the year. Chart 3When Crisis Hits, Buy Risk Assets! Our Worst Calls Of 2020 We chose a very bad time, last December, to bet heavily on global equity rotation from growth to value and away from tech sector leadership. US equities and tech stocks surged ahead of global equities on the back of the pandemic. Our long energy / short tech trade proved disastrous. Only now, with a vaccine on the horizon, are these recommendations coming to fruition. On the other hand, we should have remained committed to our long EUR-USD position rather than cutting it short when the crisis erupted (Chart 4). Global stimulus and the Fed’s sharp reduction in interest rates and gigantic infusion of US dollar liquidity ensured that the dollar would plummet. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. In some cases our geopolitical forecast proved dead-on while our market recommendation faltered. One of biggest geopolitical forecasts, in September 2019, was that the US and China could well conclude a trade deal but that it would be extremely limited in scope and strategic tensions would continue to rise dangerously. This prediction has proved accurate, judging by US high-tech export controls and China’s suppression of Hong Kong this year. But we misjudged the market response, particularly after China contained the virus: the renminbi saw a tremendous rally this year while we remained short, suffering a 4.96% loss so far (Chart 5). Chart 4Stick With Your Guns...Even Amidst Crisis Chart 5US-China Tensions Persisted, But The Market Didn't Care Along these lines, President-elect Joe Biden’s statement that he will maintain President Trump’s tariffs is another confirmation of one of our most contrarian views over the past year.1 We would expect the People’s Bank to allow the yuan to slip both to deal with lingering deflationary pressures and to build up some poker chips for the coming negotiations with Biden. We also would expect the US dollar to witness a near-term tactical bounce. However, if we are wrong, our short CNY-USD trade will fall further and we will have to cut our losses. Chart 6You Can't Time The Market Other mistakes occurred when solid economic and political views combined with bad market timing. Our long position in cyber-security stocks is well grounded – we remain invested – but once again we jumped the gun on the rotation away from Big Tech, which constituted the short end of two of our pair trades, now closed. Separately, we coupled our long gold bet with a long silver bet that came far too late into the rally – though we remain strategically optimistic on silver due to its industrial uses, which should revive in the post-pandemic context. Lamentably, we ran up against our stop-loss threshold on our structural position in US aerospace and defense stocks not long before the vaccine announcement would have begun the arduous process of recuperating losses (Chart 6). We have reinitiated the latter trade, albeit in global defense stocks rather than just American. The inverse also occurred, in which our political forecasting proved faulty but our market implications worked out quite well. One of our biggest political forecasting failures stemmed from an initial success. Beginning in May, we signaled that the US Congress would experience “stimulus hiccups” in trying to pass additional fiscal relief for the economy. This view proved prescient as negotiations fell through in July and a range of benefits expired. Real rates began to recuperate at this time. The problem is that we also predicted that the fiscal impasse was merely a hiccup, i.e. would be resolved prior to the election. It remains unresolved to this day. Fortunately, our market recommendation – to go long US municipal bonds relative to duration-matched treasuries – was rooted in the principle of “buy what the Fed is buying” and therefore continued to appreciate, along with our similarly justified position in investment grade bonds (Chart 7). Chart 7Stimulus Hiccup Occurred, But Was Not Resolved Our biggest error of political forecasting was the collapse of OPEC 2.0 at the beginning of the year. We signaled to clients in January that Russia was growing internally unstable and that this would result in an external action that would prove market-negative. This was correct, but we failed to anticipate that the most important consequence would be a temporary Russian rejection of Saudi demands for oil production cuts. Still, we advised clients to stay the course, arguing that the Russians and Saudis were geopolitically constrained and would return to their cartel, which proved to be the case, thus hastening the restoration of balance to oil markets. This view supported our long spot oil recommendation in late March, though the idea that US producers might collaborate proved fanciful. Alternatively we suggested that clients go long oil relative to gold, which has performed well. Other mistakes stemmed from our tactical trades. Generally, we were insufficiently bullish both during the summer and after the US election. In both cases we overemphasized the absence of US fiscal stimulus as a risk to the rally. In reality the first stimulus was sufficient and the V-shaped recovery of the private economy reduced the need for additional support over the course of the year. Our long tactical positions in US treasuries, consumer staples, and JPY-EUR did not pan out. The takeaway going forward, given that the market is not pressuring politicians to act, is that the risk of another congressional fiscal failure prior to Christmas is underrated. Lastly, some minor emerging market trades went awry, such as our long positions in Thai and Malay equities and our shorting the South African rand. We wrongly predicted that Michelle Obama would be Joe Biden’s pick for vice president, when in fact that honor went to Senator Kamala Harris. Our Best Calls Of 2020 While we got the big market moves right in 2020, our best calls were political and geopolitical in nature: Joe Biden won the US election. He won through his ability to win back blue-collar workers and compete in the Sun Belt as well as the Rust Belt, which we outlined as a key geographic strength during his run in the Democratic primary election (Map 1). We downgraded Trump from 55% odds of re-election to 35% in March, when the lockdowns occurred, and we upgraded Trump only to 45% in October when he rallied. The thin margins in the swing states confirmed this higher-than-consensus probability of a Trump win. Map 1Joe Biden Won The Rust Belt And The Sun Belt Republicans retained the Senate. Beginning in late September, we saw that President Trump was rallying and that this would increase the odds of a Republican Senate even if Trump himself fell short. On October 16 we signaled that the Senate was too close to call, and on October 30 we upgraded the GOP again and argued that a Democratic White House plus a Republican Senate was the most likely scenario (Chart 8). There is a lingering risk to this view: a double Democratic victory in the Georgia runoffs on January 5, 2021. But we put the odds of that at 30% at best. Chart 8Republicans Held The Senate (Pending Georgia Runoffs) Chart 9Biden Won The Democratic Primary Nomination Biden won the Democratic nomination, which we first highlighted in November 2018 and June 2019 and consistently thereafter, though we never underrated his challengers (Chart 9). Trump was acquitted of impeachment charges, which seems like ages ago. We said from the start that Democrats did not have the votes (Chart 10). China stimulated the economy massively and avoided massive domestic unrest. Investors doubted that Beijing would stimulate enough to lead to a global recovery, given the leadership’s preference to avoid systemic financial risk. We insisted that constraints would prevail over preferences and the stimulus would be gigantic. Our “China Play Index” skyrocketed, though it did not outperform global equities (Chart 11). We also argued that President Xi Jinping would not face significant domestic unrest after the crisis erupted, though we view domestic political risk as underrated for the coming years. Chart 10Impeachment Failed Long Emerging markets and deep cyclicals recovered. The combination of Chinese stimulus and a US “return to normalcy” led us to go long emerging markets after the election. We articulated this trade by going long Trans-Pacific Partnership countries, on the expectation that Washington will remain hawkish toward China over trade (Chart 12). We also went long deep cyclicals and US infrastructure plays on the basis of Chinese stimulus and the Biden-Trump common denominator on building projects (Chart 13). Chart 11China Stimulated Massively   Chart 12Long Trans-Pacific Partnership Worked As EM Play The Taiwan Strait was a bigger geopolitical risk than the Korean peninsula, which markets are at last recognizing (Chart 14). Unfortunately for investors Taiwan remains a serious geopolitical risk regardless of Trump’s exit. Hong Kong attracted investors’ attention more than Taiwan in 2020, whereas we have treated Hong Kong as a red herring. Chart 13Long Infrastructure And Cyclicals Paid Off   Chart 14Hong Kong Was A Red Herring, Korea Beat Taiwan Brexit has been a red herring throughout 2020, as expected, though an end-of-year failure to agree to a UK-EU trade deal would upend our predictions (Chart 15). Chart 15Brexit Was A Sideshow Germany’s shift to more dovish fiscal policy strengthened European solidarity, keeping peripheral bond yields and “break-up risk” contained (Chart 16). In August 2019 we argued that Germany was easing fiscal policy but would not surge spending until a crisis happened – which proved to be the case when the coronavirus prompted Olaf Scholz to wheel out the “bazooka” this year. We also argued that Europe would be willing to mutualize debt, which was officially confirmed when outgoing Chancellor Angela Merkel forged an agreement on an EU Recovery Fund with French President Emmanuel Macron (though not exactly a “Hamiltonian moment”). Chart 16European Solidarity Strengthened Chart 17Peak Shinzo Abe' Theme Boosted The Yen Japan saw “Peak Abenomics,” which was confirmed this year when he handed the helm over to his deputy, Yoshihide Suga, whose policies are continuous. Abe’s late-2019 tax hike was only one of many reasons we anticipated a rally in the yen, which was supercharged by this year’s crisis (Chart 17). Russia’s political risk premium spiked, as we expected, though we did not anticipate that the cause would be a temporary breakdown in OPEC 2.0 (Chart 18). We were more prepared for an event like the poisoning of Alexei Navalny and US sanctions against the Nordstream II pipeline. Our argument that Russia would lie low, for fear of domestic unrest, has so far borne out in the Belarus protests and the conflict in Nagorno-Karabakh. Whether it will continue to do so in the face of what will likely be a pro-democracy assault in eastern Europe from the US Democratic Party remains to be seen. Chart 18Russian Geopolitical Risk Spiked As Predicted India-China tensions were a red herring. India benefited from the western world’s turn against China. Partnerships and alliances were already taking shape before the coronavirus spurred a move in the West to diminish reliance on China’s health care exports. Our long Indian pharmaceuticals trade was highly profitable, though our overweight in Indian bonds was less so (Chart 19). Chart 19India Benefited From West's Anti-China Turn Brazilian political risk surged to the highest levels since the 2018 election, and President Jair Bolsonaro suffered a setback in municipal elections, as we expected, especially after witnessing his cavalier attitude toward the pandemic (Chart 20). However, his approval rating rose on the back of fiscal largesse, implying that debt dynamics will continue to trouble this market despite the bullish backdrop for emerging markets in 2021. Chart 20Brazil Remained A Muddle Chart 21Turkish Populism Exacted A Toll Chart 22A Bull Market In Iran Tensions The Turkish lira collapsed, as Turkish President Recep Erdogan maintained reckless domestic economic policies and foreign adventurism (Chart 21). As we go to press, Erdogan appears to be backing down from his aggressive approach to maritime-territorial disputes in the Mediterranean, for fear of European sanctions, which would be a positive surprise, albeit temporary. The “bull market in Iran tensions” continued, with US-Israeli sabotage and assassinations of key Iranian figures bookending the year (Chart 22). With Trump still in office for another 45 days, we would not be surprised to see another move on Iran, where hardliners are ascendant in the unstable advance of the Supreme Leader Ali Khamenei’s eventual succession. So far, Trump has taken market-negative actions in his “lame duck” period on Iran, China, and Big Tech, as we argued, which means more is coming despite the market’s enthusiasm over the partly sunny outlook for 2021. Investment Takeaways Geopolitical analysis is about structural themes and trends – not unpredictable black swans, which may even further entrench structural trends. When a crisis triggers a massive selloff, buy risk assets, then reassess. The gargantuan, coordinated monetary and fiscal response to this year’s crisis presented a clear buy signal. Once the virus was revealed not to be as deadly as first suspected, the rally gained steam. Political and geopolitical forecasts may be dead-on and yet fail to drive the market. There is a constant need to refine the ability to articulate and implement trades that seek to generate alpha from policy insight. Tactical views and attempts at cleverness are a liability when one’s strategic views – geopolitical, macro-economic, financial – are firmly grounded.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Thomas L. Friedman, "Biden Made Sure ‘Trump Is Not Going To Be President For Four More Years,’" New York Times, December 2, 2020, nytimes.com.

Our semi-annual virtual meeting with the long-standing client Ms. Mea took place on December 1. Given it is the end of the year, Ms. Mea inquired about our strategies for 2021 and reviewed the evolution of our views during 2020. Below is a transcript of our discussion, which we hope will help clients better grasp our views and analysis. Chart 1EM Relative Equity Performance And EM Currencies Versus DM ex-US Ms. Mea: Before we get to investment recommendations for next year, let’s review which of your views have worked in 2020 and which have not. Answer: From a big picture perspective, we went from being very negative on EM over the last decade to being neutral on EM risk assets in both absolute terms and relative to DM peers. Since April, we have been waiting for a pullback to go long and overweight EM, but a meaningful setback has not materialized. That said, although EM risk assets and currencies have rallied substantially in absolute terms, they have not outperformed their DM peers, as shown in Chart 1. Concerning the evolution of our strategy, as you might recall, we had to chase EM stocks higher late last year after the trade deal between the US and China created euphoria in financial markets, pushing EM assets higher. But even then, we did not change our bullish view on the US dollar and continued recommending an underweight allocation in EM versus DM in global equity and credit portfolios. In our January 23, 2020 report we contended that the risk premium in global markets was extremely low and that risk assets were extremely overbought. The following week, as news of the COVID-19 outbreak in China emerged, we recommended closing the long position in EM stocks. On February 20, we asserted that odds of a breakdown were substantial and recommended shorting EM stocks outright. We closed this position on March 19 with a substantial gain. On March 26, we argued that it was too late to sell but too early to buy. In retrospect, the latter part of this assessment was incorrect. Then, on April 23, we recommended going long duration in EM local currency bonds or buying domestic EM bonds while hedging currency risk. We recommended receiving 10-year swap rates in several EM countries. We changed our long-standing strategic bullish stance on the US dollar to bearish on July 9. Simultaneously, we closed our shorts in various EM currencies versus the greenback and recommended shorting many of these EM currencies versus an equal-weighted basket of the euro, CHF and JPY (please refer to the bottom panel of Chart 1).   We upgraded EM credit from underweight to neutral on June 4 and lifted the allocation to EM stocks from underweight to neutral on July 30. EM relative equity performance versus DM has been in a broad trading range for the whole of 2020 (please refer to the top panel of Chart 1). Chart 2Facing Technical Resistance Ms. Mea: What is your EM outlook going into 2021? Answer: The odds of a major breakout in EM equities, currencies and fixed-income markets have risen, yet there could be a shakeout before the breakout. Both EM equity and the global ex-US equity indexes have risen to their previous highs which proved to be a formidable resistance level (Chart 2). The main reasons to expect a major breakout in EM and global ex-US share prices are as follows: First, the global economy could experience periodic setbacks, but things cannot be worse than they were during the pandemic-induced lockdowns in early 2020. The deployment of vaccines is likely to improve global economic conditions in 2021, especially in hard hit services sectors. Second, asset purchases by major central banks around the world have effectively removed many securities (mostly government bonds) from the marketplace while creating an enormous supply of money (Chart 3). The upshot is that too much money is chasing fewer assets. Chart 4 illustrates this phenomenon in the case of US dollar securities. Cash in both US institutional and retail money market funds is still elevated. As a share of market value of US dollar denominated equities and bonds, the amount in US money market funds has declined but it is still above its February lows. Provided that US money market rates are zero, one can make the case for more flows from money markets into both equities and bonds. Chart 3Booming Money Supply Worldwide Chart 4How Much Cash On-SidelinesIs There Left In The US?   Finally, odds that EM equities will break above the trading range they have been in over the last 10 years have increased. As we discussed in our previous reports, EM ex-China, Korea and Taiwan have been facing hard budget constraints due to limited fiscal stimulus packages, a breakdown in their monetary transmission mechanism, and massive foreign capital outflows in early 2020. These harsh conditions have forced many companies to restructure to boost their efficiency. The banking system has been recognizing and provisioning for bad assets. Finally, some governments have adopted difficult structural reforms. These could be sowing seeds of structural transformation in these economies, in turn producing a secular bull market in their equities and currencies. As was discussed in a recent Country In-Depth report, India is one example where structural reforms stand to have a positive effect on its long-term outlook. Indonesia, Colombia, Mexico, and Brazil are other candidates that could undergo similar transformations. In a nutshell, unless the global economy craters – which has low odds – one can envision a scenario in which risk assets continue marching higher. Ms. Mea: However, you mentioned that there could be a shakeout before the breakout. What makes you say that? Answer: A potential shakeout before the breakout may occur due to the following three peaks: Peak investor sentiment: Investor sentiment is very elevated and risk assets are overbought. The ZEW global growth expectations index (a survey of analysts on DM economies) has rolled over after reaching an all-time high (Chart 5, top panel). The Sentix survey of investor future expectations has reached an apex (Chart 5, bottom panel). Importantly, net long positions in copper and net bullish sentiment on copper are at their previous highs (Chart 6). This is a plausible proxy for investor sentiment on both China and global growth. Chart 5Investor Expectations Are Elevated Edited Chart 6Investors Are Super Bullish On And Very Long Copper   Chart 7Investors Are Bullish On US Equities Finally, sentiment among US equity investors is also elevated (Chart 7). Peak stimulus: In China, both credit and fiscal stimulus will likely peak in Q4 2020, as demonstrated in Charts 8 and 9. The US and the euro area will experience a negative fiscal thrust in 2021 equal to 7.4% and 3.8% of GDP, respectively. A new fiscal package worth $1.5 trillion is needed in order for the US fiscal thrust to be neutral. As Republicans are likely to retain control of the Senate, even after Georgia’s Senate election vote on January 5, 2021, a new fiscal package larger than $500-750 billion is unlikely. On the whole, many countries in DM and EM are experiencing peak stimulus in 2020. Chart 8China: Peak Credit Stimulus Chart 9China: Peak Fiscal Stimulus   Peak manufacturing growth: We should differentiate between the top in a business cycle and an end in growth acceleration. As far as global manufacturing is concerned, we are likely currently experiencing growth acceleration at its height. Global manufacturing will continue to expand, but at a slower rate. Share prices could either rally or correct when growth begins to decelerate. The stock market reaction is contingent upon how overbought and how expensive equity prices are. The top panel of Chart 10 illustrates that the tops in the US ISM manufacturing new orders-to-inventory ratio have historically marked setbacks in global cyclical stocks. Similarly, EM share prices and industrial metals fluctuate with the EM and China manufacturing PMI (Chart 10, middle and bottom panels). Having risen sharply to very elevated levels, odds are that global and China manufacturing PMIs are probably topping out. Granted, these are diffusion indexes, and declines/rollovers in global manufacturing PMIs do not necessarily imply that a recession is on the horizon. Rather, they signal the end of the acceleration phase in a cycle. Bottom Line: Given how overbought and expensive they are, share prices might react negatively to peak stimulus. Ms. Mea: Your outlook on the Chinese economy has become more nuanced since the spring. How do you see China’s business cycle and financial markets evolving? Answer: We upgraded our view on the Chinese business cycle in late May after it had become apparent that China had again injected enormous credit and fiscal stimulus into the economy. On June 18, we upgraded Chinese stocks to overweight within an EM equity portfolio. We continue to expect decent growth numbers and reviving corporate profits in most of H1 2021. That said, authorities have been tightening monetary policy since May. Policymakers realize that China’s credit excesses have become even larger and they have been proactive in policy tightening to rein in leverage and speculative activities. The central bank has siphoned off banks’ excess reserves causing interbank rates to rise considerably (Chart 11). With a time lag, money/credit will decelerate and the business cycle will follow. We expect the Chinese business cycle to crest around the middle of 2021. Chart 10Cyclical Assets Fluctuate With Manufacturing PMIs Chart 11China: Liquidity Tightening Works With A Time Lag   The recent shakeout in the onshore corporate bond market will lead to a reduction in corporate bond issuance as investors now require higher yields to finance SOEs. In addition, banks and non-bank financial institutions have to comply with the asset management regulation by the end of 2021. This will restrict banks’ ability to expand their balance sheets and curb NBFI risk appetite. All in all, credit-sensitive sectors like capital spending and the property market will decelerate considerably in H2 2021. Provided that they make up a large share in the mainland economy, overall income growth will also slump. Concerning financial markets, if there is a selloff in Chinese stocks in the coming weeks or months, it will give way to another upleg later in H1 2021. Ms. Mea: Going forward, what will be the driving forces of EM risk assets and how will they shape up? Answer: EM risk assets – equities, credit markets and high-yielding domestic bonds – are by and large driven by three factors: (1) China’s import and commodities cycles (which often move in tandem); (2) domestic fundamentals in EM ex-China; and (3) sharp swings in US growth and the S&P500. (1) We elaborated on the intricacies of the Chinese business cycle above and will now offer a few insights on commodities prices. There has been a broad-based recovery in Chinese demand for commodities and various commodities prices have risen substantially. Nevertheless, the outlook for commodities prices is less certain going forward. Chart 12China's Booming Copper Imports Imply Inventory Accumulation In particular, copper prices have surged but the rally is only partially attributable to recovering real demand in China. Other forces, namely inventory restocking in China and financial (investor) demand, have been responsible for the massive rise in copper prices. The mainland’s imports of copper and copper products have boomed since spring, growing at a rate of 70-80% from a year ago. Meanwhile, the recovery in Chinese infrastructure investment in electricity, water, and gas – which are the largest consumers of copper – has been considerable but not extraordinary (Chart 12). This surge leads us to infer that a sizable inventory restocking cycle has been taking place in China since last spring. Such large inventory accumulation has likely been prompted by the easy availability of credit and rising copper prices. Besides, investors hold record net long positions in copper on the New York Mercantile Exchange (refer to Chart 6). In brief, as we discussed in detail in the Special Report from November 25, Chinese purchases of copper will decline even as its real demand for copper continues to expand. Oil prices are at risk of excess supply as many producers are reluctant to continue suppressing their crude output. Saudi Arabia has been trying hard to limit OPEC+ production. However, it will be increasingly difficult for it to do so. The basis is that many producers are naturally looking to maximize the net present value of cash flow from their oil reserves. Due to inflation, $45 today is worth more than $45 in five years. As and when oil producers accept that global demand for oil will stagnate as the world switches to more environmentally friendly sources of energy, they will have an incentive to produce and sell as much crude as possible at current prices. Chart 13EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices If Saudis lose control over output, they will ramp up their own production to increase their market share. Crude prices will plunge anew. The timing is uncertain, but we expect it to happen sooner rather than later. Overall, even though China’s business cycle recovery will continue in H1 2021, prices for certain important commodities like oil and copper will likely struggle. Setbacks in commodities prices will have ramifications for financial markets in resource-producing EM countries. EM currencies, as well as their sovereign spreads, correlate with commodities prices (Chart 13). (2) Domestic demand in EM ex-China, Korea and Taiwan will gradually improve but from a very low point. Many developing countries still face major hurdles, including banking systems that are struggling with non-performing loans, a looming fiscal drag, and a lack of control over the pandemic. Further, EM outside North Asia will lag behind advanced countries in procuring and deploying COVID-19 vaccines. Consequently, consumer and business confidence will be slow to recover in these countries, and their business cycle revival will continue to trail that of North Asia (China, Korea and Taiwan) and advanced economies. (3) Finally, any shakeout in the S&P500 will reverberate through EM. Having rallied considerably, North Asian equity and currency markets have already priced in a great deal of good news. In EM ex-North Asia, the level of economic activity, albeit reviving, remains low. This makes these EM ex-North Asian financial markets very sensitive to fluctuations in global/US financial markets. Chart 14EM Equities Have Been A Low-Beta Play On The S&P500 The resilience of US equity and credit markets in recent months in the face of numerous challenges has surprised us. US share prices and credit markets have not corrected meaningfully despite (1) the third wave of COVID-19 which has resulted in partial lockdowns and a deterioration in consumer sentiment; (2) the lack of a second fiscal stimulus package and (3) uncertainty surrounding the presidential elections. In retrospect, investors have been willing to buy any small dip. Interestingly, in the past three years, EM share prices outperformed DM share prices when the S&P500 sold off and underperformed when US stocks rallied (Chart 14). EM versus DM relative share prices are shown inverted on this chart. This reveals that EM stocks are not a high beta on the S&P 500 and rising US equity markets do not guarantee that EM share prices will outperform their DM peers. Overall, the outlook for EM risk assets is convoluted, warranting a neutral stance for now both in absolute terms and relative to DM. Chart 15The US Dollar Is Oversold Ms. Mea:  Where and how does the US dollar enter your analysis? Answer: The dynamics between EM and the US dollar is push-pull in nature, i.e., the causality runs both ways. EM fundamentals – that could be broadly defined as return on capital in these economies – drive their exchange rates’ trends versus the US dollar. Further, US dollar trends are also shaped by several global macro forces, including the global business cycle. The US fiscal position and monetary policy stance also drive fluctuations in the value of the greenback. Over the next several years, the US dollar will likely be in a bear market because US inflation will rise and the Federal Reserve will fall behind the inflation curve. US real rates will remain negative, which will continue to undermine the dollar’s value. All that said, the US dollar has become very oversold and investor sentiment is bearish on the greenback (Chart 15). From a contrarian perspective, the dollar might be set up for a countertrend rebound. Interestingly, after the 2016 US elections, the US dollar rallied strongly for several weeks before selling off violently. It seems that the broad trade-weighted dollar is now following a reverse pattern (Chart 16).  The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has continued weakening since. If this reverse pattern were to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 16The US Dollar Before And After 2016 And 2020 Presidential Elections Chart 17EM Stocks Are Cheap If The Structural EPS Trend Is Up In short, a long-term bear market but near-term rebound in the US dollar is consistent with our view of a shakeout before a breakout for EM equities and risk assets. Ms. Mea: What about EM equity and currency valuations? Are they not still cheap despite their recent rally? Answer: From a secular perspective, EM equities appear modestly cheap as illustrated by our cyclically-adjusted P/E (CAPE) ratio (Chart 17). However, it is vital to realize that this CAPE valuation model assumes that EPS (earnings per share) in real (inflation-adjusted) US dollar terms will revert to its long-term trend sooner rather than later (Chart 17, bottom panel). There is a lot of uncertainty regarding the structural trend in EM EPS. For the past decade – and therefore well before the pandemic – EM EPS in nominal US dollar terms has been fluctuating in a wide range (Chart 18). Not surprisingly, EM share prices have been flat for the past ten years. Further, EM EPS has massively underperformed US EPS in local currency terms for the past ten years (Chart 19). Consistently, EM share prices have underperformed the S&P 500 even in local currency terms. Chart 18EM EPS: No Growth For 10 years Chart 19EM Versus US: Relative Stock Prices And Relative EPS   As for EM currencies, the aggregate real effective exchange rate of EM ex-China, Korea, Taiwan currencies suggests that they are cheap (Chart 20). Overall, to argue that EM stocks are cheap, one should be confident that EM EPS in real (inflation-adjusted) USD terms will be expanding in the years to come (Chart 17, bottom panel). While some EM economies have undertaken some restructuring, there is currently no strong evidence to suggest that EM EPS will be in a structural uptrend. From a cyclical perspective, EM EPS will certainly be recovering in 2021 (Chart 21). However, a notable chunk of this profit recovery has already been largely priced in. Chart 20EM ex-China, Korea, Taiwan: Currency Valuations Chart 21EM Profits Will Recover In 2021   To sum up, a bet on EM share prices breaking out above their decade-long trading range implies betting on EM EPS entering a period of structural growth. Over the past ten years, EM companies have not delivered the secular growth needed to warrant higher equity multiples. We are open to the idea that structural reforms carried out in several nations will allow for higher productivity, income and profit growth. However, it is still too early to jump to that conclusion. Chart 22Will Asian Markets Finally Break Out? Ms. Mea: Where in your analysis and strategy might you be wrong? Answer: The key risks to our view are twofold: First, FOMO (fear of missing out) on the part of investors continues to propel EM risk assets higher while either their fundamentals remain mediocre or they are already very expensive. As we have shown in Chart 4, there is still a lot of US dollar cash sitting in US money market funds and these could feed the EM rally, preventing the materialization of a shakeout. Second, we might be late to recognize structural shifts in certain EM economies and, might therefore miss breakouts in those bourses. Notably, there is no single EM equity market that has clearly broken above its previous highs (Chart 22). Ms. Mea: What are your overweights and underweights for equity, currency and fixed-income portfolios? Answer: For an EM equity portfolio, our strong conviction overweights have been and remain China, Korea and Mexico. Chart 23 shows the performance of our fully-invested EM equity portfolio based on our recommended country allocation. It has outperformed the EM MSCI equity benchmark by 3.7% in 2020 and by 74% since its initiation in May 2008. The latter translates into a 4.7% CAGR outperformance versus the EM MSCI equity benchmark in 10.5 years. Critically, this outperformance has been achieved with very low volatility and small drawdowns. Chart 23Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) As for EM local bonds, we continue to recommend receiving ten-year swap rates in Korea, Malaysia, Russia, Mexico, Colombia, South Africa, China and India. We are looking for a setback in their currencies to switch to holding cash bonds, i.e., without hedging currency risk. Among EM currencies, our short basket consists of BRL, CLP, ZAR, TRY and IDR while our favored ones have been MXN, RUB, CZK, INR THB and SGD. All these country recommendations and positions as well as the one in the EM sovereign credit space (US dollar bonds) are always presented at the end of our reports (please refer to the following pages). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dr. Copper has gone ballistic of late, breaking out to multi-year highs. While there is an element of speculative fervor, global growth is ascending and China’s demand for commodities remains insatiable (top panel). Copper’s recent spike signals that EUR/USD will likely decisively break above the 1.20 ceiling (bottom panel), a message that China’s immense easing corroborates as we highlighted last week. The Fed was adamant in debasing the US dollar as a way to reflate not only the US but also the global economy as we highlighted early on in the recovery in early-May. Now the Fed has passed the baton to investors and USD bears are squarely in control. The implication is that a positive feedback loop of a falling currency and rising global growth is great news for commodity producers. We expect a V-shaped recovery in the cyclicals/defensives profits on the back of the budding economic recovery the world over (middle panel). Bottom Line: Continue to prefer deep cyclicals at the expense of defensives.

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations