Financial Markets

Special Report

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin Chart 13China Pares Local Government Spending Too Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation Chart 17The Case For US Inflation Chart 18The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China Chart 27No Inflation In China Chart 28No Inflation In China Chart 29No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are ElevatedChart 36Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force Chart 38A Mania In Full Force Chart 39A Mania In Full Force Chart 40A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese StocksChart 45Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks Chart 62The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

Dear client, In lieu of our regular report next Friday, we will be sending you a special report on Australia next Tuesday, co-authored with our Global Fixed Income colleagues. We hope you will find the report insightful. Kind regards, Chester   Highlights Any tactical bounce in the dollar should be limited to 2-4%. A barbell strategy is the most attractive positioning in the next one to three months: a basket of the cheapest currencies and some safe havens. Remain short the gold/silver ratio. Feature Chart I-1Dollar Downside Hits Q1 Forecasts The market narrative towards the dollar is turning more bullish. Fundamental analysts point to the recent rise in US interest rates, relative to countries like Germany or the United Kingdom, as a serious cause for concern. A rules-based technical approach certainly warned that the dollar was getting much oversold last year, and the recent bounce is reinvigorating the possibility of a more powerful countertrend move. Being in the dollar-bearish camp, the key question is: how large could a potential dollar bounce be, and for how long can it last? According to Bloomberg forecasters, the dollar has already exhausted any potential decline penciled in for the first quarter of this year. Q1 consensus forecasts for the DXY index sit at 90, exactly where the index level rests today (Chart I-1). Bloomberg has consistently lowballed the level of the dollar since 2018, making the current forecast unduly bullish. This dovetails with recent market commentary that the decline in the dollar is largely done, and powerful catalysts for a countertrend move could take hold. Risks From The Reflation Trade Chart I-2A Stock Market Rout Could Derail The Dollar An equity market correction could be one of the potential catalysts that pushes the dollar higher. We showed last week that the dollar and the S&P 500 have had a near-perfect inverse correlation (Chart I-2). When a stock market and its currency exhibit an inverse correlation, it means that foreign investors have been hedging their equity purchases by selling the currency forward. This is not usually the norm (equity relative performance and currencies tend to move together), but was especially the case last year as inflows into US equities surged, but the dollar declined. Should any profit taking ensue, this will trigger a knee-jerk rally in the dollar, as forward shorts are closed. A few equity indicators warn that we could be at the cusp of such a counter-trend move:  The put/call ratio in the US is extremely depressed. This warns that positioning is lopsided and could easily topple the equity market rally. A rising put / call ratio has been synonymous with a higher dollar over the past few years (Chart I-3). This will be consistent with foreign investors unwinding their dollar hedges (as they take profits on equities) and/or safe-haven inflows into the dollar. Chart I-3Both Puts And The Dollar Offer Protection Cyclical stocks continue to outperform defensive ones of late, but the cracks are beginning to emerge, specifically in the industrials space. Industrials share prices have been relapsing of late (Chart I-4). The dollar tends to weaken when cyclical stocks are outperforming defensive ones, and vice versa. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. The huge correction in the relative performance of the global tech sector also warns that the tech-heavy US bourse might benefit from any bounce in tech equities. Global earnings revisions are heading higher, but the momentum of US earnings has regained the upper hand, especially relative to the euro area. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. Relative earnings revisions between the US and other markets have led the dollar by about nine to 12 months (Chart I-5). Should cyclical earnings hit a soft patch as the pandemic engulfs much of the developing world, the more defensive US market might prove resilient. Chart I-4A Red Flag From Global Industrials Chart I-5Earnings Revisions And The Dollar In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume. In similar fashion, a washing out of stale US dollar short positions will ensure the bear market for 2021 unfolds with higher conviction. A garden-variety 5-10% cyclical correction in the S&P 500 has usually coincided with a 2-4% bounce in the DXY, as can be seen from Chart I-2. This could be the story over the next one to three months. The Signal From Currency Markets Our dollar capitulation index hit a nadir in July last year and has since been rebounding from very oversold levels. It has been very rare that a drop in this index below the 1.5 level did not trigger a rebound in the dollar (Chart I-6). Part of the reason this did not happen this time around has been concentration. Dollar short positions since 2020 have mostly been against the euro, yen and Swiss franc, with positioning in currencies such as the Australian dollar and Mexican peso more neutral. This will limit the extent to which the broad dollar index could rise from a flushing out of stale shorts. Chart I-6BCA Dollar Capitulation Index Suggests Some Upside For example, the exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate. Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently tracked the drawdown of the broad equity market (Chart I-7). As the bottom panel shows, exuberance in the AUD/JPY cross has also coincided with equity market peaks.  That exuberance hardly exists today. The AUD/JPY cross has consistently tracked the drawdown of the broad equity market. That said, speculators are very short the dollar, even if the currencies used to implement these views are very concentrated. Sentiment towards the dollar is the lowest in over a decade and our intermediate-term indicator is at bombed-out levels (Chart I-8). Chart I-7AUD/JPY As A Risk On Gauge Chart I-8The Dollar Is Oversold In a nutshell, the message from technical indicators is that a bounce in the dollar is to be expected. However, the magnitude will be smaller than prior episodes. Ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different.  The Dollar And Commodities Commodity prices across the board have been on a tear. This has usually been an environment where the dollar is in a broad-based decline. Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. More importantly, rising commodity demand can signal an improving FX trend between commodity producing (Australia, Canada, Mexico, Colombia, Russia) and importing (Euro area, India, Turkey, or even China) countries. We will buy the currencies of commodity producers on weakness as the bull market continues. Metals prices have exploded higher on strong demand, especially from China (Chart I-9). Not surprisingly, speculative positioning in copper options and futures is also extremely elevated. If investors have been betting on higher copper prices, based on the expectation of a lower dollar, then a relapse in the red metal will be synonymous with a higher greenback. That said, commodity bull markets have tended to last over a decade, with the recent rise in prices also driven by deficient supply. As such, we will buy the currencies of commodity producers on weakness, rather than sell on strength, as the bull market continues. This also argues for a fleeting technical bounce in the dollar. Chart I-9A Bull Market In Metals Chart I-10The Gold/Silver Ratio is Rebounding Within the commodity space, watching the gold/silver ratio (GSR) is instructive. The GSR tends to track the US dollar (Chart I-10). This is because it has usually rallied on safe-haven demand and relapsed once there is a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. It is possible the surge in global infections dampens economic activity and lifts demand for safe havens. This will be good for the dollar. However, as vaccinations take hold and the economy reopens, silver will surge. Relative Interest Rates Interest rates are moving in favor of the dollar, and there has been a long-standing relationship between relative real rates and the US currency. The question is whether the rise in US interest rates has been sufficient to compensate investors for the higher budget deficits they will need to finance. To answer this, it is always instructive to look at the relationship between gold and US Treasuries. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s.  The bond-to-gold ratio is an important signal for the dollar, since both US Treasuries and gold are safe-haven assets and thus, by definition, are competing assets (Chart I-11). The ratio of the US bond ETF (TLT)-to-gold (GLD) is an important proxy for investor sentiment on the dollar (Chart I-12). Ultimately, investors are driven by real rates. Positive real returns will favor Treasuries, while negative real returns will favor gold. The latter appears to have the upper hand for now. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s. Chart I-11Gold and Treasurys Are Competing Assets Chart I-12Watch The Bond-To-Gold Ratio The implication is that the rise in US interest rates has not yet convinced investors that a significant margin of safety exists for possible runaway inflation. This augurs badly for the dollar, beyond the near term. Investment Implications Our investment strategy is simple: hold a basket of the cheapest currencies and, some safe havens that will benefit if the dollar bounces. Opportunities at the crosses also make sense. On safe-haven currencies, our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Relative value is particularly attractive on short CAD/NOK, long AUD/NZD, short EUR/GBP and long EUR/CHF. Stick with them. Stay short USD/JPY and long the Scandinavian currencies as a core holding. Remain short the gold/silver ratio.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been resilient: The headline 140K job loss last Friday was not as dire, looking into the details. There was a net two-month revision of +135K jobs. Core CPI came in line at 1.6% year-on-year, while average weekly earnings surged by 4.9%. MBA mortgage applications came in at a blockbuster 16.7% week-on-week, for the week ending on January 8. The DXY rose by 0.3% this week. There was some element of consolidation in markets earlier this week, with a few equity bourses softening and the dollar catching a bid. However, that has been overwhelmed by the reflation trade as we go to press. We expect any dollar bounce to be technical in nature, and in order of magnitude of around 2-4%.  Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have help up: The unemployment rate in the euro area fell from 8.4% to 8.3% in November. Sentix investor confidence remains resilient at 1.3 in January, versus -2.7 the previous month. Industrial production in the euro area is recovering, as signaled by the PMI releases. The euro fell by 0.5% against the US dollar this week. The unfolding political crisis in Italy warns that the euro might be due for a setback, as European peripheral bond spreads rise. We remain bullish the euro longer-term, but short-term trades are at risk from lopsided positioning.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been better than expected: The expectations component of the Eco Watchers Survey rose from 36.5 to 37.1, versus expectations of 30.5 in December. Machine tool orders continued to inflect higher in December, to the tune of 8.7% year-on-year. Bank lending remained around a robust 6% in December. The Japanese yen was flat against the US dollar this week. Japanese fixed income investors are in a quagmire, since nominal rates are better in the US, but real rates are more favorable in Japan. The yen could remain caught in a tug of war between these forces, with a slight advantage to Japanese rates. We remain long the yen as a portfolio hedge.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was scant data out of the UK this week: BRC like-for-like sales rose by 4.8% year-on-year in December. The British pound rose by 0.8% against the US dollar this week. Vaccinations continue to progress smoothly in the UK, but cracks are already starting to emerge in the post Brexit UK-EU relationship. There are mounting food shortages in Northern Ireland and a hiccup in fish exports from the UK, as the necessary paperwork adds a layer of bureaucracy. As investors digest the potential impact to the pound, it will add to volatility. Ultimately, a cheap pound should outperform both the dollar and euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 There was little data out of Australia this week: The final retail sales print was 7.1% month-on-month in November. The Australian dollar appreciated by 0.4% against the US dollar this week. Base metals, especially copper and iron ore have been on a tear this year. This is boosting Australian terms of trade. More importantly, a shortage of ships has catapulted Asian LNG prices to all-time highs as a cold spell hits countries like Japan and Korea. This should be beneficial for Australian energy producers. We are currently long AUD/NZD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: REINZ house sales rose by 36.6% year-on-year in December. Building permits rose 1.2% month-on-month in November. The New Zealand dollar fell by 0.3% against the US dollar this week. The release of the US WASDE report confirmed a looming agricultural shortage, as production forecasts were slashed on weather worries. This is NZD bullish. That said, technically, agricultural prices are stretched, and so some consolidation will deflate air off the high-flying kiwi. In a commodity basket, we prefer the Aussie that is underpinned by more structural factors. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been disappointing: Employment fell by 62.6K jobs in December. However, this was driven by 99K part-time job losses, with full-time job gains of 36.5K. The sales outlook in the BoC survey improved from 39 to 48 in 4Q 2020. The Canadian dollar appreciated by 0.5% against the US dollar this week. Oil prices are dominating commodity gains this year, given the shift from Saudi Arabia and the prospect of higher transport demand. This bodes well for the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been mixed: The unemployment rate was flat at 3.4% in December. FX reserves increased from CHF 876 billion to CHF 891 billion. The Swiss franc fell by 0.2% against the US dollar this week. The biggest risk to Switzerland and the SNB authorities is a potential correction in the euro, which encourages safe-haven flows into the franc. This will also be a risk to our long EUR/CHF position. Our bias is that the valuation cushion on the cross provides an ample margin of safety. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: Headline CPI came in at 1.4% year-on-year, while underlying CPI was a whopping 3%. House prices rose 2.9% quarter-on-quarter in Q4. Industrial production came in at -0.9% in November, an improvement from -2.7% the previous month. The Norwegian krone is the best performing currency this year at +1.5%. Good management of the COVID-19 situation as well as rising oil prices have been positive catalysts. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden has been rather disappointing: Private sector production fell by 1% year-on-year in November. We would expect this to reverse with the improvement in the December PMIs. Industrial orders rose 5.7% year-on-year in November. Household consumption fell 5% year-on-year in November. The Swedish krona has been the worst performing currency this year, falling by 0.7% against the US dollar this week. That said, it might be a case of profit taking. The Swedish krona remains cheap and should benefit from an upshot in the global manufacturing cycle. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Long-term investors should remain in the stock market – because central banks’ explicit commitment to financial stability will force them to crush bond yields in response to any major pullback in the $500 trillion worth of risk-assets. Given that stock market valuations are an inverse and exponential function of bond yields, crushing bond yields can give stock prices a massive boost. Hence, the structural bull market in stocks will end only when long-dated US bond yields approach zero. Nevertheless, expect a near-term exhaustion within the bull market, given stretched tech valuations and a fragile 65-day fractal structure of stocks versus bonds. Maintain a near-term tilt towards defensive sectors such as healthcare and utilities, and stock markets with a high exposure to these sectors, such as Switzerland and Portugal. Expect a countertrend rally in the dollar. Fractal trade: underweight Korea. Feature Chart I-1AStocks Became Unhinged From The Economy...   Chart I-1B...And Became Hinged To The Bond Yield, Inversely And Exponentially Investment strategy is about a lot more than macroeconomics. As my colleague Garry Evans points out, the best investors seek wisdom from many other disciplines: statistics, psychology, organizational theory, geopolitics, history, climate science etc. In 2020 the list added three new subjects: virology, epidemiology, and immunology. The lesson is that investors need to be heterodox. To this end, Garry has published a list of non-finance books that are essential reading for all investors, available here https://www.bcaresearch.com/reports/view_report/31160/gaa.  Yet despite the multi-disciplinarian inputs to an investment outcome, most investment strategy is not heterodox, it remains stubbornly orthodox – placing primacy on macroeconomics. The canonical form is, here is my outlook for economy X, so here is my outlook for stock market X. This primacy of macroeconomics is dangerous, because stock markets have become increasingly unhinged from the economy. How Stocks Became Unhinged From The Economy… Stock markets have become increasingly unhinged from the economy for three reasons. Stock markets have become increasingly unhinged from the economy. The first reason is that, to varying degrees, the composition of a stock market has become very different to the composition of the economy. Consider Denmark. Its stock market has a 41 percent weighting to healthcare and biotechnology, of which 21 percent is in the multinational pharmaceutical company, Novo Nordisk.1 Suffice to say, with such a heavy skew to global pharma and biotech, the Danish stock market has absolutely no connection with the Danish economy (Chart I-2). Chart I-2Denmark = Long Biotech Now consider the much larger UK stock market. The oil sector contributes less than 1 percent to UK GDP, yet it contributes almost 20 percent to the sales of UK listed companies (because of the £0.5 trillion multinational sales of BP and Royal Dutch). Add in all the other multinational revenues and you will find little connection between UK listed companies’ sales and the UK economy (Chart I-3). Chart I-3Oil And Gas Is Overrepresented In The UK Stock Market Versus The UK Economy A similar story holds true for the largest stock market of all, the US stock market. The tech sector contributes less than 5 percent to US GDP, yet it contributes 12 percent to the sales of the US listed companies. This significant overexposure to tech means that the aggregate sales of US listed companies are not representative of the US economy (Chart I-4). Chart I-4Tech Is Overrepresented In The US Stock Market Versus The US Economy But what about the global stock market? The global stock market also has different sector skews compared with the global economy. This explains why, in 2015, the sales of global listed companies unhinged from a growing global economy, and suffered a severe and ‘hidden’ -11 percent recession, worse even than that suffered during the global financial crisis of 2008-09 (Chart I-5). Chart I-5Stock Market Revenues Suffered A Severe 'Hidden' Recession In 2015 The second reason that stocks are unhinged from the economy is the obvious point that the stock market is a discounting mechanism. Stocks are priced off the economy not as it is now, but as the market expects it at some future date. But what future date? The answer is: it varies. The market is composed of investors with many different time-horizons, ranging from day traders to multi-year horizon pension funds. In practice though, the long-term horizons tend to be fluid, sometimes compressing to focus on market momentum, sometimes re-expanding and reconnecting to a valuation anchor such as expected sales or profits. The shorter that the average time horizon of the stock market is, the more unhinged the market becomes from the valuation anchor. When the time horizon ultimately re-expands, the stock market reconnects with its valuation anchor, sometimes violently. Hence, it is crucial to monitor the average time horizon of the market using fractal analysis. And beware if the time horizon has compressed too far. The third reason that stocks can unhinge from the economy is that valuation extremes can dominate the price. To the extent that a weaker economy depresses the bond yield, and that valuation is an inverse exponential function of the bond yield, the paradox is that a much weaker economy can cause much higher stock prices. That was the story of 2020 (Chart of the Week). The corollary is that the perception of a stronger economy, by pushing up the bond yield, can depress stock and other risk-asset prices. This is a big worry because the total worth of global risk-assets, at $500 trillion, dwarfs the $90 trillion global economy by more than five to one.2  To their credit, central banks now understand this major risk, evidenced by the explicit addition of ‘financial stability’ to their mandates. Put simply, if stock and risk-asset prices fell far enough, central banks would be forced to crush bond yields.  …And What To Do About It Having gone through the three reasons why stocks are unhinged from the economy, we can now advise on three ways that investors should respond. Avoid the canonical form, here is my outlook for economy X, so here is my outlook for stock market X. First, avoid the canonical form, here is my outlook for economy X, so here is my outlook for stock market X. In a few cases of X, such as Germany and Norway, there is a reasonable connection between the economy and stock market, but these are the exceptions. Mostly, the connection is either non-existent, as in Denmark and the UK, or tenuous, as in the US (Chart I-6 and Chart I-7). Chart I-6Little Connection Between GDP And Stock Market Revenues In The UK... Chart I-7...And ##br##Europe Instead, think in terms of the composition of the stock market. It is the sectors and stocks that dominate the stock market, rather than the local economy, that will drive its performance. Second, always monitor the average time horizon of the market (or any investment), and beware if it compresses too far. This is identified by the fractal structure breaking down, warning of a potential instability. For example, as we presaged last week in Stocks Are Vulnerable… And So Is Bitcoin, the reason that bitcoin has just suffered a 20 percent pullback was that the time horizons of its investors had compressed too far. Specifically, bitcoin’s 130-day fractal structure had collapsed, just as it had before previous pullbacks in late 2017 and mid-2019 (Chart I-8). Chart I-8Bitcoin's Investor Time Horizons Compressed Too Far Third, swings in stock market valuations swamp the changes in the economic fundamentals. And the driver of these valuation swings is the bond yield, inversely and exponentially. Hence, if you get just one thing right, that one thing must be the bond yield. Some Investment Conclusions The most important conclusion is that investors who can ride out pullbacks should remain in the stock market. The simple reason is that central banks’ explicit commitment to financial stability will force them to crush bond yields in response to any major pullback in the $500 trillion worth of risk-assets. Given that stock market valuations are an inverse and exponential function of bond yields, crushing bond yields can give stock prices a massive boost – as we witnessed last year during the sharpest economic contraction in a century. One important takeaway is that the structural bull market in stocks will end only when bond yields can no longer be crushed. As bond yields in Europe and Japan are already close to their lower bound, this effectively means that bull market in stocks will end only when long-dated US bond yields approach zero. Long-term investors should stay in stocks until then. Nevertheless, as we detailed last week, we anticipate a near-term exhaustion within the bull market, for two reasons. First, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has presaged four previous market exhaustions. Second, the average time horizon of stocks versus bonds has compressed too far, evidenced by a fragile 65-day fractal structure (Chart I-9). Chart I-9Stock Versus Bond Investor Horizons Have Compressed Too Far Hence, for the near-term, maintain a tilt towards defensive sectors such as healthcare and utilities, and stock markets with a high exposure to these sectors, such as Switzerland and Portugal. Expect a countertrend rally in the dollar. Finally, expect a countertrend rally in the dollar, given that in the short term the dollar is just the perfect mirror-image of the stock market (Chart I-10). Chart I-10The Dollar Has Been The Perfect Mirror-Image Of The Stock Market Fractal Trading System* The near-vertical rally in the Korean stock market is vulnerable to a setback given that both the 130-day and 65-day fractal structures have collapsed. Accordingly, underweight MSCI Korea versus MSCI AC World, setting a profit target and symmetrical stop-loss at 10.6 percent. Chart I-11MSCI Korea Vs. MSCI All-Country World In other trades, long XLU versus XLB was closed at its stop-loss. The rolling 12-month win ratio now stands at 60 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on Datastream indexes. 2 The $500 trillion comprises $300 trillion in real estate plus $200 trillion in other risk-assets such as equities, corporate bonds, and EM debt. 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Highlights Structural reform is coming to the US in the wake of the riotous 2020 election cycle. Extreme levels of political polarization will subside, albeit remaining relatively elevated. This will smooth the way to a more proactive fiscal policy that secures the economic recovery. The Biden administration has enough political capital to pass large fiscal stimulus, an expansion of Obamacare, and an increase of taxes, regulations, and the minimum wage. The Republican Party will go into the political wilderness – and it may not recover from its internal struggle in time for the 2022-24 elections. Moderate Republicans will assist in passing legislation. Stay cyclically long stocks over bonds, cyclicals over defensives, and value over growth, but introduce tactical hedges. Go long VIX.  Feature Structural reform is coming to the United States in the wake of the riotous 2020 election cycle. The incoming administration of President-elect Joe Biden will usher in a stabilization of US politics by means of a substantial increase in fiscal support for the economy. This provides a backstop for the recovery that, combined with the ultra-accommodative Federal Reserve, suggests investors should keep an optimistic attitude toward risk assets over the coming 12 months, despite the inevitable ups and downs (Chart 1). Biden and the establishment politicians of both parties are beset by rising forces of populism on the right and left. They likely recognize that their political survival, as well as the country’s stability, depends on maintaining the recovery. The soon-to-be ruling Democratic Party narrowly obtained the majorities necessary to pass at least a few major laws. Chart 1Biden's First 100 Days Triggers Brief Pullback The change in political leadership will be beneficial for the middle class household but  less so for Big Business and corporate earnings. The US faces a rocky historical transition toward larger government involvement in the economy, more restrictions on private enterprise, and more redistribution of wealth. Labor is taking up a larger share of national income, as opposed to capital – a big shift away from the trend of the past 40 years (Chart 2). That period was extremely friendly to equity investors. The future will be trickier, though for the time being the market is pricing the good news. Chart 2Labor Makes A Comeback Versus Capital In this report we lay down our three key views for 2021: Peak Polarization – US political polarization is at extreme levels and though it will subside in the wake of the feverish 2020 cycle, it will remain elevated in the coming years. There will be aftershocks from the past year’s crises. Extremism and political violence will continue to flare up with the possibility of domestic terrorist incidents. The market impact of this trend is inherent in the Democratic victory in the White House and Congress, but the Biden administration’s political capital will increase upon any major shocks stemming from extreme polarization. Bipartisan Structural Reform – Investors should expect a flurry of legislation. The Democrats will be anxious to reward their base and consolidate power. Moderate Republicans will assist on some votes. New taxes and spending, a higher federal minimum wage, a larger safety net (e.g. healthcare), and administrative reforms will all ensue. Republicans In The Wilderness – The Republican Party is hereby exiled into the political wilderness to settle its internal struggle over Trumpism. The Party of Lincoln will somehow survive but it may not recover by 2024. Below we explain these views, what would undermine them, and what they mean for investors over the next 12 months and beyond. View #1: Peak Polarization US political polarization hit extreme levels over the past year according to various measures (Chart 3). Polarization will retreat as a result of Biden’s victory over Trump – Biden will have a higher approval rating, both generally and among the opposite party, than Trump did. But it will remain elevated relative to history. Structural drivers of polarization, such as wealth and racial inequality, congressional gerrymandering, and regional disparities, remain unaddressed. It will take time to reduce them. Hence, US social and political instability will continue in 2021. Most of this will be noise but some of it will not. Chart 3Polarization At Extremes Chart 4Terrorism On The Rise In The USThere will be aftershocks in the wake of the Trump rebellion on January 6 and the House Democrats’ decision to impeach him for a second time. A massive show of force will attend Biden’s inauguration, but extremism and political violence of various kinds have been flaring in recent years and will persist for some time (Chart 4). Both the FBI and the Department of Homeland Security have warned of a rise in domestic extremism and terrorism. Increased political instability creates fertile ground for malign actors of all stripes to operate, including domestic or foreign saboteurs. At a critical juncture in the nation’s politics like today, a major attack could wreak more panic and uncertainty than otherwise would be the case. The past year of unrest shows that the bar is high for markets to respond to passing political events. But a major crisis event that has systemic importance cannot be ruled out in today’s precarious environment. In the event of a major domestic terrorist incident, such as the 1995 Oklahoma City bombing, the vast majority of the public would react with utter revulsion and rally around the flag (Chart 5), while the federal counterterrorism response would be overwhelming, just as it was in the 1990s. Chart 5OKC Bombing Spurred Rally Round The Flag The market impact of such an attack would be fleeting. Other domestic incidents bear this out, such as the Waco siege (1993), the Olympic Park bombing in Atlanta (1996), the Charleston church massacre (2015), and the shooting of Republican lawmakers in 2017 (Chart 6). This point is intuitive given the extensive rioting and unrest in 2020 yet the fall of market volatility throughout the year. Yet the past year’s social and political instability does have major investment implications. It has led to full Democratic control of Congress and the White House on an agenda of fiscal expansion and wealth redistribution. Chart 6Market Largely Ignores Domestic Terrorism What About Long-Term Effects? With the government supporting the economy, it is less likely that the US will experience a drastic backslide into even greater social instability in the coming years. On the contrary, a more proactive fiscal policy, with more robust social safety nets in terms of health, unemployment, child care, and old age, means that social stability should improve (Chart 7). If the material wellbeing of the country fails to improve, or if exogenous events further destabilize the US, then the social and political environment will deteriorate further. But we would expect that 2021 will see the US secure the recovery and begin to restore order, at least temporarily. Longer term stabilization will require a succession of improvements that span administrations.  Chart 7Better Social Safety Net Could Reduce Deaths Of Despair Bottom Line: The Biden administration’s political support will increase if there are any major attacks and that support will be used to restore order. The market ramifications of any such response are already known: expansive, proactive fiscal policy to stabilize the economy and society and thus reduce the odds of greater division and radicalization. This kind of stabilization is positive for risk assets over a 12-month horizon. View #2: Bipartisan Structural Reform Investors should bet on a flurry of legislation from the Democrats (Table 1). They will be anxious to reward their base, consolidate power, and restore the political establishment to a position of primacy. They will be determined to act quickly, remembering how the 2010 midterms stymied their agenda after winning a blue sweep in the wake of the last major national crisis. Table 1Biden’s Priority? Stimulus … And More Stimulus Not only do Democrats control Congress but also Republicans are divided – by their loss of the Senate and by Trump’s rebellion. Over the coming year, moderate Republicans will be much more likely to vote with Democrats than the latter will be to defect from their party, especially on popular legislation such as economic stimulus (Chart 8). Chart 8Biden’s Priority? Stimulus … And More Stimulus If Republicans prove obstructionist then we would not rule out the Democrats mustering the votes to remove the Senate filibuster. But in the current climate, several moderate Republicans, such as Alaska Senator Lisa Murkowski, Pennsylvania Senator Pat Toomey, and Utah Senator Mitt Romney, are looking to distance themselves from Trump and Trumpism. Opposition to government spending has lost a lot of steam in US politics. The populist Republicans are increasingly willing to accept large spending to ease burdens on their voter base. Trump was a big spender, and the Republicans passed large spending bills during his term. Republicans have supported large household rebates as a COVID relief measure, as our Global Investment Strategy points out. These include prominent Senators like Lindsey Graham of South Carolina as well as presidential hopefuls like Marco Rubio of Florida and Josh Hawley of Missouri. Granted, desperate times call for desperate measures – Republican fiscal hawkishness will return now that the party is in the opposition. But there can be little doubt that Republican fiscal discipline has eroded given that both populists and moderates have loosened their standards. Austerity will not have as much support in the 2020s as it did after 2008. There is no chance that Democrats and Republicans will agree on a 2011-style Budget Control Act in the near future. The budget deficit will normalize albeit at a higher level than before the crisis (Chart 9). Chart 9Budget Deficit: Larger For Longer Democrats are guaranteed to drive a big spending agenda through Congress. They have the votes, the popular support, and the lingering COVID crisis as added impetus. The voting record of the Obama administration reinforces the high likelihood of Democratic unity as well as moderate GOP support (Chart 10). Chart 10Obama Era Shows Democrats Will Pass Legislation What About Tax Hikes? Congress will also raise taxes sooner or later. The party is united on the need to tackle economic inequality. There is no clear relationship between marginal tax rates and economic growth, capital spending, or productivity, according to our US Investment Strategist Doug Peta. If anything a positive correlation exists between corporate tax rates and economic growth, suggesting the right time to increase taxes is when the economy has recovered from recession or is otherwise in full stride (Chart 11). Nevertheless it is intuitive that a big tax hike could weigh on growth when it is first rolled out. Chart 11A Growing Economy Enables Tax Hikes So there is a good basis for the Biden administration to delay raising taxes until the recovery is secure. However, taxes will go up sooner or later (Chart 12). Chart 12Corporate Tax Rate Will Rise Sooner Or Later But The Economy Can Power Through It Taxes must rise to pay for new spending and, in the Democratic Party’s view, redress inequality. The use of the budget reconciliation procedure to pass laws with a simple majority in the Senate will necessarily require revenue offsets over a ten-year window to pay for new spending. The Trump tax cuts were never very popular to begin with, so the political blowback is manageable (Chart 13). Any delay would be temporary and thus its positive effects would be counteracted by the expectations of firms and investors. Passing tax hikes in 2021 enables COVID to serve as a pretext for a larger round of spending increases than would otherwise be possible to offset the new tax burden. Taxes can be passed in 2021 but not take effect until 2022. That might prevent the full impact from hitting ahead of midterm elections that year. Democrats hope to pick up two seats in the Senate, bringing their majority to 52-48 and bringing the more controversial parts of their agenda within reach. Chart 13Trump Tax Cuts Were Never Very Popular Note also that the Biden administration aims only partially to repeal the Trump tax cuts. The new corporate tax rate will rise to no more than 28%, which is still seven percentage points lower than Trump found it in 2016. Nor is Biden projecting a higher top marginal individual rate than the 39.6% that prevailed before Trump. The minimum corporate tax rate of 15% will bring a bigger negative impact for firms but it will be politically popular. There could also be a financial transactions tax, which Biden has said he supports. All of this is achievable with Senate control (Table 2). Table 2Biden’s Fiscal Agenda Investors should expect an early hit to earnings expectations. There will be an earnings hit from the simultaneous increase in taxes, regulations, and the doubling of the minimum wage to $15 per hour. Moreover investors need to price in more than Biden’s agenda. They need to price in a broader shift in US policy to redistribute wealth from capital to labor. Firms will face a new paradigm that is less corporate-friendly and laissez faire, at least until the Republican Party recovers and offers a viable alternative. And as discussed below, that could take a while. Bottom Line: The Biden administration will pass big new increases in spending and taxation as well as minimum wages and a slew of new regulations on labor and the environment. The shift to a fiscally proactive US government, at a time when the Fed is ultra-dovish, will ensure that the positive market reaction continues for the most part of the coming 12 months. But sooner or later markets will have to discount a generally more intrusive government that will reduce profit margins. View #3: Republicans In The Wilderness The Republican Party will go into the political wilderness in 2021, where it faces an internal struggle over how to deal with Trump and Trumpism. In the short run this means Republicans will not be well organized to oppose the Biden administration. In the long run, the outcome of this internal struggle will have a historic impact on the overall US policy outlook. Trump has become the first president to be impeached twice. There are eight days until Biden’s inauguration at noon on January 20. The Senate, still led by Republicans, has scheduled the trial to take place after that time, but it may still be relevant. If Trump is tried and convicted, which requires a two-thirds vote, then he could be disqualified from holding any future office on a simple majority vote. Otherwise, Congress could censure him, which would be merely symbolic. The Democrats hope to force Republicans to go on the record after Trump’s interference with the peaceful transfer of power to force them either to break with their party or wear the Trump albatross forevermore. Republican senators are not as reliable for Trump in any new impeachment as in the first one. A vote to remove, disqualify, or censure him would enable them to wash their hands of his actions. This could be useful for swing state moderates. The problem for the GOP is that it is still beholden to Trump, who generated large voter turnout and won 47% of the national vote, despite a pandemic and recession. Trump has left the party in better condition, in terms of seats, than his predecessor George Bush did (Chart 14). If he leaves the GOP and starts his own party, he could bring anywhere from one-third to half of Republican voters with him and thus hobble the party semi-permanently (Chart 15). It has happened before in US history.1 Chart 14GOP Still Fairly Strong In Congress, State Capitol Chart 15If Trump Leaves, He Could Take One-Third To Half Of GOP Voters A high-stakes negotiation will have to be held in a smoke-filled back room. Trump wants the 2024 nomination; the GOP wants his base. A solution would involve the GOP exculpating Trump yet again while he shepherds his base over to a successor within the party. But there is deep distrust. Trump was never a normal Republican and now he is even at odds with Vice President Mike Pence, Senate Leader Mitch McConnell, and his former chief of staff Mick Mulvaney. The party is losing donors over Trump’s actions, as companies withdraw support in the name of democracy. Moderate lawmakers and high-profile Republicans are trying to sever ties with Trump and considering leaving the party. If Republicans convince Trump to put away his 2024 aspirations and support the party, they may recuperate fairly quickly, on a populist basis. If they cannot, then the party may split, whether formally or informally, and hand the Democrats a decade-long ascendancy in US politics. Trump has shown that his base is too small to win against a fully mobilized Democratic-led political establishment. But without his base the Republicans definitely cannot win. The Republican Party will thus experience varying degrees of fracture in 2021. So far, Trump says he will run in 2024 and there is no reason to doubt him. But this is moot if the Senate agrees to impeach. This means the party is almost guaranteed to suffer a lasting split that will undermine its prospects in 2022, which would normally be fairly strong, and set up a bloody primary election in 2024. If this is the path the party embarks on in 2021, then investors should expect the Biden administration to be more effective than its narrow majorities suggest in passing legislation. Bottom Line: The Republican Party will suffer a deep fissure, or split entirely apart, depending on President Trump’s actions in the coming years. The implication is that the GOP opposition will be mostly ineffective in Washington in 2021. Moderate senators will be liable to vote with the Democratic majority on major bills. This is especially true of bills relating to COVID relief, economic stimulus, health care, or administrative reform to prevent 2020 election debacles from happening again. Investment Takeaways US equity markets and risk assets will eventually suffer a correction when the market comes to grips with the Biden administration’s capabilities and the looming rise in taxes, regulations, and wages. A stock market drop around Biden’s inauguration and first 100 days would fit the pattern of new “sweep” governments with single-party control. Timing is always tricky especially because the market is exuberant about the combination of larger fiscal and monetary stimulus. Stock prices are technically extended, expensive, and vulnerable to a negative growth surprise, but we would be buyers amid an equity pullback as the policy and macro fundamentals remain supportive. We are bullish over the 12-month horizon, especially in the first half. We are long stocks, the stock-to-bond ratio, value over growth, infrastructure plays, and reflation plays. Fiscal spending will go up quickly with new legislation, whereas tax hikes could be delayed. The implication is that the deficit will get larger and the yield curve will steepen, which is beneficial for cyclical and value plays. When tax hikes come into focus – which we expect to be soon – the tech sector will be the first casualty. We are long materials relative to Big Tech and would also be constructive toward energy relative to tech. The sectors that face the greatest policy risks under the Biden administration – health care, energy, financials – are also the ones best positioned to capitalize on the fresh burst of policy reflation, especially the latter two.   Big Pharma and the health insurers clearly face higher policy and regulatory risks. We recommend going tactically short S&P managed health care relative to the broad market. Consumers stand to benefit from stimulus measures that add to their already formidable pile of savings and provide more robust safety nets. Consumer discretionary stocks will also benefit from the normalization of the economy. Thus we view consumer plays favorably in general and recommend going long consumer staples as a tactical hedge.     As another tactical hedge we recommend going long volatility (VIX).   Several clients have asked about the drop in Twitter’s share prices upon its announcement that President Trump would be permanently removed from the platform. In general, we expect a drop in polarization to coincide with a drop in tech outperformance (Chart 16). The reason is that a slight increase in bipartisanship will result in fewer fiscal cliffs and policy-induced shocks, thus helping inflation expectations recover. This will benefit value stocks more so than growth. The Biden administration is allied with Big Tech but the threats to this sector are sprouting up in both political parties and from every direction – from anti-trust authorities, state-level governments, privacy advocates, free speech advocates, foreign tax authorities and regulators, and unions. We will discuss the latest controversies regarding Big Tech and free speech/press in future reports but for now suffice it to say that the macro and policy landscape is shifting against Big Tech. The big five tech firms may still see their stock prices rise but they will underperform the other 495 companies on the S&P. Chart 16Polarization And Tech Go Hand-In-Hand   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com     Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Namely in the 1912 election when Theodore Roosevelt left the Republican Party and started the progressive “Bull Moose” party, costing incumbent President William Howard Taft the election versus Democratic challenger Woodrow Wilson. One could loosely interpret Texan Ross Perot’s presidential runs in 1992 and 1996 in a similar vein, and perhaps that would be more applicable to any future independent run by President Trump.  

Highlights The incidents of state-owned enterprise (SOE) bond defaults late last year reflected deteriorating corporate balance sheets and exposed local governments’ weakening fiscal positions. Both were preexisting conditions that worsened due to the pandemic. China’s policymakers have vowed to accelerate restructuring the SOE/corporate sector, but they face a dilemma between economic stability and painful reforms; the outcome will ultimately depend on policymakers’ pain thresholds. In the next 6 to 12 months, the policy tightening cycle will continue and credit growth will decelerate. Chinese stocks are already more expensive than before the start of the last policy tightening cycle. We recommend a neutral position on domestic and investable stocks for now. Feature The days of China’s unconditional bailout of state firms may be over. In the past six months, Beijing has embarked on a series of reform agendas, including restructuring and stricter regulations targeting SOEs and the broader spectrum of the corporate sector. When three SOEs defaulted on bond payments late last year, neither the central nor the local government supported those firms. Allowing market forces to allocate capital to more productive firms by driving out the less efficient companies is structurally positive for the Chinese economy.  However, the pursuit of meaningful SOE and broader corporate reforms will be a tough choice for Chinese policymakers this year while the economic recovery is underway. Ultimately, the degree and speed to reform SOEs will depend on how much near-term pain policymakers are willing to endure. We recommend a neutral position in Chinese stocks for now. We expect the financial markets to experience frequent mini-cycles in 2021 due to policy zigzags. Risks for policy miscalculations cannot be ruled out; equity prices will falter if Chinese authorities push for deeper reforms and tighter industry regulations while scaling back stimulus at the same time. Chinese stocks are already expensive and are vulnerable to authorities opting for much smaller stimulus and harsher corporate/SOE reforms. SOE Defaults: Policy Response Matters More Than Defaults Chart 1Policy Zigzags And Market Mini-Cycles A flurry of high-profile defaults by state firms late last year unnerved investors and pushed up onshore corporate bond yields. Beijing’s move to allow SOEs to fail forced investors to reprice bonds issued by state firms as much riskier propositions. Following the defaults in November, the PBoC injected unusually large interbank liquidity; the de jure policy rate dropped and Chinese stock prices rallied (Chart 1). In our view, the recent liquidity injections do not provide enough evidence that macro policy is shifting to an easier bias. Despite a retreat in the short-term interbank rate, the authorities have plowed ahead with reforms and initiated more restrictions in key industries. In the coming months, investors should expect the following: SOE reforms will tolerate more bond defaults. Bank loans and local government bonds make up nearly 80% of China’s total domestic credit, whereas corporate bonds (including SOEs and local government financing vehicles (LGFVs)) account for only 10% of the total (Chart 2). Thus, even if corporate bond defaults push up yields, Beijing may see this as a small price to pay in the near term, in exchange for a market-driven system cleansing to eliminate inefficient SOEs. This outcome will be negative for corporate bonds (Chart 3). Chart 2Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Policymakers may underestimate the unintended consequences of SOE defaults on credit flow and the broader economy. The central bank was able to engineer a sharp drop in its policy rate last month, which may prompt policymakers to believe that interbank liquidity injections are efficient market-calming measures and rising corporate bond yields will not impede overall credit growth. This may be true in the short term, however, tightened policy in the name of reforms has previously pushed up both the 3-month SHIBOR and bank lending rates, leading to a significant slowing in credit growth and an eventual slowdown in economic expansion (Chart 4). Reasons for such chain reactions are twofold. First, banks become more risk averse during a tightening cycle and charge higher premiums when lending to smaller financial institutions and the private sector (Chart 4, bottom panel). Secondly, although Chinese SOEs can borrow from banks at much lower interest rates than private-sector entities (Chart 5), their heavy indebtedness makes them hyper-sensitive to even a slight uptick in financing costs. Chinese SOEs rely more on bank lending than bond issuance for financing and SOE borrowers dominate China’s bank credit to the corporate sector.1  Chart 6 shows that the rise in the weighted average lending rate in 2017 was relatively minor compared with levels that prevailed in the past decade. Nonetheless, a less than one percentage point hike in the lending rate materially slowed credit growth and the investment-driven sectors of China's economy. Chart 5SOEs Tend To Have Lower Borrowing Costs, Partially Reflecting Implicit Government Guarantees Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth   Regulatory pressures will lead to de facto tightening. As outlined in our 2021 Outlook report, as part of the macroeconomic policy normalization, credit growth will likely decelerate by two to three percentage points this year from 2020. The extended Macro Prudential Assessment (MPA) System will wrap up by year-end and financial institutions will need to start slowing their asset balance sheets to meet the assessments. Moreover, last week the central government revised Measures for the Performance Evaluation of Commercial Banks. The modified version factors lending to the new-economy sectors and micro and small enterprises into the performance evaluation and salaries of the state-owned and controlled commercial banks’ management.2 The new measures will likely dampen the banks’ propensity to lend to old-economy sectors, such as real estate and traditional infrastructure. All in all, a faster-than-desired slowdown in credit growth will ensue if policymakers simultaneously allow more SOE/corporate defaults, undertake industry reforms, and implement tighter banking regulations in 2021. This is negative for both economic growth and the equity market. Bottom Line: Chinese policymakers will likely allow more SOE defaults in the coming months. In addition to an increased number of SOE defaults that is negative for the corporate bond market, sped up industry restructuring and more stringent regulations may lead to a sharp fall in credit growth and stock prices. Worsening Old Economy SOEs’ Financial Positions Chart 7SOEs Are Less Efficient Than Private Firms In Profitability And Productivity An acceleration in SOE reforms may trigger near-term risks, but a delay in restructuring China’s loss-making SOEs will have repercussions in the long term. The explicit and implicit government protections for SOEs have eroded their efficiencies compared with the private sector (Chart 7). The most significant side effect is a rapid rise in SOE leverage and diminishing profitability in some of the old economy sectors. It may be a dead end for the government to continue bailing out state firms with inefficient operations and financial losses. A Special Report we previously published  showed that among SOEs in the industrial and construction sectors, which account for half of all SOEs in China, the adjusted return on assets (ROA) versus borrowing costs has been negative since 2013 (Chart 8). This suggests that SOE investment funded by higher leverage cannot produce sufficient income to repay debt. During the last tightening cycle that started in late 2016, policymakers managed to rein in local SOE debt growth, but it reversed course in 2018 due to a collapse in domestic demand (Chart 9).  As Chart 8 illustrates, ROA among SOEs in the industrial and construction sectors has significantly deteriorated since then. Chart 8SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly Bottom Line: A continued capital misallocation by perpetually leveraging SOEs and LGFVs with negative marginal operating gains will eventually lead to a self-reinforcing debt trap. In turn, that would precipitate a default en masse and necessitate a larger government bailout. Another Layer To The SOE Reform Dilemma The central government’s SOE reform agenda is further complicated by the involvement of local governments (LGs). We have several observations: First, a meaningful SOE restructuring, which would require consolidating/liquidating some of the unprofitable SOE assets, may expose the LGs’ fiscal vulnerabilities to both investors and regulators. The fiscal weakness of China’s provincial-level governments is illustrated by the bond-payment default of Yongcheng Coal, a SOE from Henan Province. Henan is economically sound with GDP growth above the national average. However, when considering the province’s direct and hidden debt, debt servicing costs, and liquidity availability, Henan is in a group of 10 provinces with the worst fiscal conditions in 2020.3 This implies that LG officials may not have been able to bail out Yongcheng even if they wanted to. Moreover, cash-strapped LGs have reportedly formed reciprocal and entrenched relationships with local SOEs. These SOEs may carry debt for LGs and in turn, free up an LG’s borrowing capacity. When these SOEs fail, the credibility of LG officials may be questioned and investigated by the central government. As such, LGs are incentivized to protect their local SOEs.  Chart 10More Defaults, More Bank Lending Secondly, removing the government’s bailout of SOE debt defaults does not negate the underlying factor eroding SOE productivity: the government’s support of local SOEs with easier access to bank loans. Banks, which heavily influence LGs, are not always vigilant about risks associated with local SOE debt. Banks provide loans at preferential rates to localities and their affiliated SOEs. In return, LGs often award banks financing opportunities for profitable infrastructure projects. In this regard, local SOE bond defaults are not necessarily detrimental to bank profits because banks can make up their losses through financing more lucrative projects. Studies show that even when some LGs have experienced large-scale SOE bond defaults, lending to these LGs from commercial banks actually increased relative to other forms of financing (Chart 10). Beijing must take bold measures to break up the long-standing relationship between LGs and SOEs in order to achieve any market-oriented reform of local SOEs. The LGs will likely strongly resist severing the connection. Lastly, given that SOEs are often deployed to support the central government’s economic, political and strategic initiatives, LGs can use those grand initiatives to help justify their local SOEs’ existence - even unprofitable ones. Bottom Line: Beijing faces a tough choice between implementing effective SOE reforms and worsening local governments’ fiscal conditions with negative implications for economic growth. While allowing more SOE bond defaults can force investors to reprice SOE credit risks, as long as the implicit government support for SOEs through bank lending still exists, allocating capital to more efficient private-sector companies will be a formidable task. Investment Conclusions Some economists argue that China’s SOE debt should be considered part of public-sector leverage because many SOE investments are affiliated with government projects. Additionally, Chinese SOEs have accumulated massive assets, which can more than offset their debt4 and make SOE bonds and debt low- risk propositions. Moreover, even though the government may allow more SOE bond defaults, if the defaults threaten China’s financial stability, then the government can move non-performing debt from LGs and SOEs to the balance sheets of the central bank or central government. There are several issues with this argument. The stock of assets in a large portion of Chinese SOEs5 has persistently failed to generate sufficient cash flow to service debt, which implies that the true value of the assets may be low and will likely be sold at below cost when liquidated. It is not useful to compare book value of assets with debt because the true value of assets is contingent on the income/cash flow that they generate. We agree that public-sector leveraging/deleveraging is fundamentally a political choice in countries with control over their own monetary policy and debt is in local currency. Theoretically, a country can monetize public and private local currency-denominated debt via a central bank or government- controlled commercial banks. In such a case, the authorities will have little control over inflation, the exchange rate, and the long-term productivity.   For now, Chinese policymakers seem to be on a path of accelerating reform, an indication that they want to avoid bailing out state firms and private-sector companies. In addition, President Xi’s “dual circulation” mantra emphasizes the importance of improving the country’s corporate efficiency and productivity. We think that consolidating some inefficient SOE sectors in the old economy fits such initiative. Our baseline view is that the SOE consolidation process will be gradual and the PBoC will provide sufficient liquidity in an effort to prevent market jitters. At the same time, the sharp turns in the policy rate in the past six months are prime examples of the periodic oscillation in China’s policymaking between maintaining economic stability and pursuing meaningful reforms. The policy swings will create mini-cycles for Chinese risk asset prices. Chinese stocks are not cheap compared with values at the start of the last policy tightening cycle (Chart 11A and 11B). We recommend a neutral position on domestic and investable equities for the time being. CHART 11AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Based on the OECD estimates, SOEs’ share of China’s total corporate debt escalated from 46% in 2013 to roughly 80% in 2018.  2Banks included in the new appraisal system are state-owned and state-controlled commercial lenders, and other commercial banks may also refer to the guidelines. Lenders will be evaluated yearly and the results will be factored into the annual reviews of top bank executives as salary determinants. Each of the four new categories will carry an equal weighting. The “national development goals and real economy” category has four benchmarks: serving the government’s “ecological civilization strategy” to encourage lending for green industries and companies; serving strategic emerging industries; implementing the “two increases” - inclusive lending to micro and small enterprises; and implementing the “two controls” - nonperforming loans and borrowing costs of micro and small enterprises. The category “controlling and preventing risks” includes metrics on bad loan ratios, the nonperforming loan growth rate, provision coverage, liquidity ratios and capital adequacy ratios. 3“Seeing Through the Frosted Glass: Assessing Chinese Local Governments’ Creditworthiness”, Pengyuan Rating Public Finance Report, June 2020 4Chinese SOE assets are estimated to have reached 2.3 times China’s 2019 GDP, whereas their debt is close to 130% of GDP. 5IMF estimated that about a quarter of Chinese SOEs were operating at a loss in 2017. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.