Europe

Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Special Report

Highlights The dollar has entered a multi-year decline. However, in the very near term, we are at risk of a tactical bounce, which should be in the order of 2%-4%. Eventually, the DXY should hit 80 in 2021. This will lift the euro towards 1.35. The best-performing currency in 2021 will be the Norwegian krone. The Swedish krona will be a close second. The story for 2021 will also shift from broad dollar weakness to playable themes within the currency market. This entails more differentiation among currency losers and winners. Our ranking model suggests USD, NZD, and CHF will be the underperformers. The value-versus-growth debate will be one theme that will emerge as an important driver of currencies. Exchange rates for countries with a heavy weighting of value stocks in their domestic bourses will outperform.  Currencies of oil-producing countries will also outperform those of oil-consuming ones. The Japanese yen remains a viable portfolio hedge for 2021. Gold and silver will rise in 2021, but silver will outperform gold. Remain short the gold/silver ratio, which was our top trade in 2020. Feature Our key conclusions from last year’s outlook were as follows:1 Go short the DXY index with a target of 90 and a stop loss of 100. The top-performing G10 currencies in 2020 will be the NOK and SEK. Remain short USD/JPY as portfolio insurance. The path to a lower yen is via an overshoot, as the Bank of Japan will need a shock to act more aggressively. A weak dollar will support  gold prices. Gold will also benefit from abundant liquidity and persistently low/negative real rates. EUR/USD should touch 1.18, while GBP/USD will retest 1.40. Chart 1The US Dollar Is Breaking Down Most of these calls have panned out as we initially expected. Granted, we did not forecast the pandemic, and the first half of 2020 torpedoed much of our expectations. But we were quick to reimplement a lot of these trades throughout the year. EUR/USD has just kissed the 1.20 mark, while GBP/USD is a whisker below 1.35, even though there has not yet been a full resolution to the Brexit imbroglio. The best-performing developed market currency this year has been the Swedish krona, while the Norwegian krone and Australian dollar are up almost 30% from their March lows. Even the Japanese yen has appreciated by about 4% against the US dollar this year. In a nutshell, 2020 has been a story about broad dollar weakness (Chart 1). This has been rooted in three fundamental pillars: Unprecedented liquidity injections by the Federal Reserve, especially in terms of addressing the offshore dollar shortage. The world is now awash with dollars, as the Fed remains the most aggressive central bank in printing domestic currency. This has compressed the US’ interest rate advantage vis-à-vis  the rest of the world. A strong and synchronized rebound in global growth, as we slowly emerge from the depths of the pandemic. As a counter-cyclical currency, the dollar has suffered. This is both a combination of Asia having been able to keep the pandemic under wraps and focus on reopening its economy, as well as a pickup in manufacturing activity around the world. Fiscal stabilizers have been able to contain a more severe contraction in global consumption. Economies more levered to Chinese growth have seen a pickup in their economies, especially versus the US. This has supported capital flows back into these economies, buffeting their currencies in the process. Much of these trends will continue into next year. However, 2021 will be a year of differentiation rather than broad-based dollar weakness. What this means is that the dollar will still decline in 2021, but more money will be made at the crosses as playable themes begin to pan out. Meanwhile, in the very near term, the dollar is due for a technical reset. The Dollar In A Market Reset The dollar rarely rises or declines in a straight line, and most indicators suggest that the dollar is deeply oversold. Having broken below major trendlines, the DXY index is now sitting at the same critical spot where we suspected it would begin to see some technical resistance. Chart 2A Surge In Bullish Positioning For EUR/USD Chart 3Risk: The Dollar And Equity Markets In fact, it has been remarkable that the dollar has not risen so far, given that November has been a seasonally strong month for the dollar since the 1970s, and that the dollar has tended to stage meaningful rallies into year-end since the GFC. From a positioning perspective, sentiment on the anti-dollar (the euro) is quite ebullient (Chart 2). Such positioning has usually been associated with a correction in the EUR/USD cross and a tactical bounce in the dollar. There are three reasons why we could experience a tactical bounce in the dollar: The greenback has had a near-perfect inverse correlation with risk assets, and the latter are due for a reset after a strong month in November (Chart 3). Sentiment on stocks is quite fervent, as measured by the American Association of Individual Investors and the equity put-to-call ratio. The pandemic is still raging in many countries (Chart 4). While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Real rates have started to rise again in the US, compared to the rest of the world. Real rates remain much lower in the US, but the small improvement in both nominal and real yields will curtail some foreign outflows from the US Treasury market (Chart 5A and 5B). Chart 4Risk: Covid-19 Still Prevalent, But Cresting Chart 5ARisk: Interest Rate Differentials Moving In Favor Of The US Chart 5BRisk: Interest Rate Differentials Moving In Favor Of The US As we discussed with Mr. X this week, the DXY has about 2%-4% upside, but not much more. For one, we no longer have the liquidity issues that handicapped global markets in March this year. The outstanding swap lines between major central banks and the Federal Reserve is close to zero, suggesting that most foreign official entities have ample access to dollar liquidity (Chart 6). This was also a signal in 2009 that the dollar liquidity shortage was behind us. While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Second, the Fed has also been the most aggressive central bank in increasing its supply of its domestic currency, as we have argued above. Today, interest rates around the world are at zero. Therefore, the onus is now shifting to central bank balance sheet policy (and/or forward guidance) to communicate the future path of interest rates. Chart 7 shows that other G10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has been hurting the dollar and benefiting other currencies Chart 6Dollar Liquidity Crisis Addressed Chart 7The Fed Is Stimulating The Most Third, US growth is set to lag the rest of the world in 2021. The IMF expects global growth to rebound by 5.2% in 2021. This will be driven by emerging markets (such as China, at 8%) but also Europe, at 5.2%. The US is expected to lag, with growth at 3.1%. Relative growth between the US and the rest of the world has been an important driver of the dollar over the last few years (Chart 8). If US growth lags over the next few quarters, it will be a headwind to the dollar. Chart 8The Dollar And Relative Growth An Attractiveness Ranking For Currencies As the dollar declines in 2021, the Scandinavian currencies remain most primed to benefit. Chart 9 ranks the G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone is especially attractive as a 2021 play. Chart 9The Scandinavian Currencies Are Very Attractive More specifically, the Scandinavian currencies have borne the brunt of the dollar bull market that began in 2011, and could see quick reversals as we enter into a multi-year dollar decline (Chart 10). Exchange rates tend to be extremely fluid in discounting a wide set  of economic data, and in the case of Sweden, in discounting the outcome for global growth. With EUR/SEK and USD/SEK still at levels close to their 2008 highs, the room for mean reversion remains quite wide.  Chart 10Buy Some NOK and SEK On Weakness Chart 11The NOK And Oil Markets The Norwegian krone is also primed to benefit from the reopening of economies, particularly through the terms-of-trade channel. As an oil producer, Norway benefits from rising oil prices. This is why the Norwegian krone has been closely correlated with the relative performance of the global oil and gas sector (Chart 11). The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. More importantly, the attractiveness ranking allows us to easily devise trading strategies at the crosses. In our portfolio, we are long NOK/EUR, CAD/NZD, EUR/CHF, and JPY/USD. We are looking to buy the Scandinavian currencies on a 2% pullback. EUR/USD As The Anti-Dollar The most liquid beneficiary of dollar downside will be the euro. As we posited in our report last month, beyond near-term weakness, EUR/USD could touch 1.50 over the next few years.2 Below are the conclusions of the report: The euro has been driven over the last few years by the relative growth performance between the Eurozone and the US (Chart 12). The IMF expects euro area growth to bounce by about 5.2% next year, compared to 3.1% in the US. Much of the rise will be due to a surge in investment in the euro area, especially driven by pent-up demand in the peripheral countries. Chart 12EUR/USD And Relative Growth From the 1960s up to the Great Financial Crisis, trend productivity growth was around 2.2% in the US and 2.8% in the euro area. However, since 2009, productivity growth has been 0.6% per year in the euro area and 1.1% in the US (Chart 13). In other words, the European debt crisis has substantially subdued productivity growth in the region. As a thought experiment, if we assume European productivity growth plays catch up over the next decade, it will be roughly 1.6% higher in Europe relative to the US. Cumulatively, that is a rise by over 20%. Given that the euro is undervalued by over 10%,3 this pins the euro well above 1.50. Ultimately, European growth is cyclically tied to export growth. And with a huge concentration of cyclical sectors – such as financials, industrials, materials and energy – in European bourses, the euro tends to be largely driven by procyclical flows. Rising inflows into European bourses will be a positive catalyst for the euro. Chart 13Could European Productivity Surprise To The Upside? The euro has been lagging other cyclical assets like copper or global stocks (Chart 14). This suggests that the current breakout has been a catch-up phase. While we are likely to consolidate gains in the very near term, the euro should ultimately head higher. Our 2021 target for EUR/USD is 1.35. Chart 14The Euro Is Still Lagging Copper Currencies And The Value Versus Growth Debate The debate about the performance of value versus growth will have a significant bearing on currencies in 2021. We discussed this topic in depth in our special report last summer.4 In a nutshell, getting the value versus growth call right could be key to targeting the currencies likely to outperform in 2021. The debate about the performance of value versus growth will have a significant bearing on currencies in 2021.  Table 1 shows that value sectors have been heavily concentrated in countries with more cyclical currencies such as the Australian dollar, Norwegian krone, Swedish krona, and Canadian dollar. It has also been the case that the performance of value versus growth has tended to lead the US dollar by about a year or so. Table 1Sector Weights Across G10 Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case where value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Chart 15 shows that a basket of the CAD, NOK, AUD, and SEK (heavily weighted in cyclical sectors) relative to the CHF (heavily weighted in growth sectors) has tracked a global value/growth basket pretty closely. Given the massive underperformance over the last decade, room for mean reversion in value stocks is immense and meaningful. This will lead to powerful inflows into currencies such as the CAD, NOK, SEK, and AUD. Another playable strategy at the crosses will be US versus non-US growth. For example, the Canadian economy is more economically linked to the US than, say, the Norwegian economy. As a result, CAD/NOK has tended to track the DXY index quite well (Chart 16). And so, while both the Canadian dollar and the Norwegian krone will rise in 2021, the CAD should greatly underperform NOK. Chart 15Value Versus Growth And Currencies Chart 16A Cheaper Way To Play Dollar Downside Oil Consumers Versus Oil Producers One reason CAD will also underperform NOK has been the tectonic shift in oil markets. In short, the NOK benefits more from oil prices than the CAD, given that it is less reliant on US oil imports. There has been a disconnect between the price of oil and the performance of petrocurrencies over the last decade. During much of the early 2000s, petrocurrencies outperformed along with rising oil prices. However, from the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar (Chart 17). We have written about this at length, and the key reason is that the US is now the largest oil producer in the world. As a result, while rising oil prices are bullish for petrocurrencies, being long versus the US dollar is no longer an appropriate strategy. From the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of the pandemic. Transport constitutes the largest share of global petroleum demand. As economies reopen, oil demand should inflect higher. However, playing this trend requires an adjustment: Being long a basket of oil producers versus consumers, rather than the US dollar. Chart 18 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with  oil prices and has outperformed a traditional petrocurrency basket Chart 17Petrocurrencies Versus Oil Chart 18Oil Producers Versus Oil Consumers In our portfolio, we are long a basket of CAD, NOK, COP, RUB, and MXN against the euro. We intend to tactically play oil upside throughout 2021 via this new strategy. On JPY And CHF Chart 19The Yen And The Dollar Are Inversely Correlated In an environment where the dollar is in a broad-based decline, most currencies will do well, as was the case this year. This is also the case for safe-haven currencies, such as the Japanese yen and the Swiss franc. But as we argued with Mr. X earlier this week, there are even more compelling reasons to hold the yen in an FX portfolio. First, the yen is cheap. Falling prices in Japan over the years have tremendously improved the fair value of the yen on a PPP basis. Second, Japan has one of the highest real rates in the developed world. So, outflows from JGB’s are going to be curtailed, while inflows might actually accelerate. And finally, both the DXY and USD/JPY are positively correlated, meaning when the dollar declines, the yen rises, but less so than other currencies. This correlation tends to shift during crises, when the yen generally appreciates more than the dollar (Chart 19). This places the yen in a very enviable “heads I win, tails I don’t lose too much” position.  The Swiss franc is likely to fare worse than the yen. First, it is more expensive, and the fact that deflation is becoming more prominent in Switzerland will force the Swiss National Bank to fend off any additional currency strength. A Final Word On Gold, Silver, And Precious Metals We agree with our commodity strategists that gold is due for a tactical bounce.5 Investors had piled into gold on the bet that a raging pandemic, combined with unprecedented monetary and fiscal stimulus, was a potent cocktail for currency debasement and inflation. With positive vaccine news on the horizon, these trades are being violently unwound. A flushing out of stale longs is very healthy in our view, since our bullish thesis has never been dependent on the pandemic in the first place. Here are the reasons: Almost every major economy now has negative real interest rates. While within the foreign exchange sphere, it is relative interest rate policy that matters, the global landscape is extremely fertile for upside in gold prices. Gold has a long-standing relationship with negative interest rates, even though the correlation has shifted over time (Chart 20). The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income generating assets such as gold. And while odds are on the side of yields  creeping higher from current low levels, this will still be bullish for gold, if driven by rising inflation expectations. Chart 20Real Rates And Gold Support for the dollar is fraying at the edges. For the first time since the end of the Bretton Woods system, central banks are becoming net purchasers of gold. Central bank purchases are extremely potent in any bull market, since historically, central banks have been indiscriminate buyers. Foreign central banks have been amassing tremendous gold reserves, almost to the tune of the total annual mine output. This diversification into gold has occurred mostly via the dollar (Chart 21). Jewelry demand is a significant chunck of gold purchases, and rising emerging market currencies have improved their purchasing power for gold. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different. Chart 21Gold And Diversification In a nutshell, we believe we have entered an assymetic reality for gold prices. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and speculation. This might be the reason why gold is decoupling from the traditional variables that drive its price. Gold was rising along with the dollar for much of 2019.  As gold rises in 2021, the true winners will be the other precious metals, especially silver6 and platinum. As such, a hedged trade likely to continue being profitable is short gold versus silver. As gold rises in 2021, the true winners will be the other precious metals, especially silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 22). This is simply because silver tends to rise and fall more explosively than the price of gold. The reason is that the silver market is thinner and more volatile, with futures open interest much smaller than that of gold. Meanwhile, silver’s larger industrial use benefits from new industries such as solar power and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Chart 22Gold Versus Silver And The Dollar Chart 23GSR: A Long Term Profile Second, when gold tends to make new highs (as it did in 2020), silver tends to follows suit as well. That is why over the centuries, the GSR has tended to mean-revert (Chart 23). That means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both  gold and palladium prices (Chart 24). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters.7 Chart 24Platinum Is Attractive Concluding Thoughts Chart 25FX Trading Model Our currency positions, as we enter 2021, largely reflect the themes and ideas developed above. Our full trade table is available on page 19. These include: The DXY will bounce to 95, but then retrace back to 80 over the course of 2021. An attractiveness ranking reveals the most appealing currencies are NOK, SEK, and JPY, while the least attractive are CHF, USD, and NZD. We are positive on both gold and silver, but prefer the latter. We are short the gold/silver ratio at a level  of 80, with a target of 65. One point we have not discussed in this report is our trading model, which continues to perform well. This models remains short the USD. We will continue to enhance this model in the coming years, as we incorporate more of our thought methodology into it (Chart 25).8   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2020 Key Views: Top Trade Ideas," dated December 13, 2019. 2 Please see Foreign Exchange Strategy Special Report, "EUR/USD: Towards Parity Or 1.50?" dated November 20, 2020. 3 Please see our Foreign Exchange Strategy Weekly Report, "Updating Our PPP Models," dated November 13, 2020. 4 Please see our Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. 5 Please see our Commodity & Energy Strategy Report, “Gold Correction Has Run Its Course,” dated December 3, 2020. 6 Please see Foreign Exchange Strategy Weekly Report, “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019. 7 Marleny Arnoldi, “Palladium/platinum substitution tech unveiled by BASF, PGM producers”, Creamer Media’s Mining Weekly, dated March 10, 2020. 8 Please see our Foreign Exchange Strategy Special Report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades