Currencies

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Duration: A survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Credit Cycle: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. IG Valuation: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk. Feature Chart 1Recession Risk Getting Priced Out The bond sell-off continued last week, driven by positive developments in US/China trade negotiations and tentative signs of stabilization in some global growth indicators. The renewed sense of economic optimism has reduced the recessionary risk priced into bond markets. The 2/10 Treasury slope has steepened 30 bps since it briefly inverted in late August. During that same period, the 2-year Treasury yield is up 15 bps, the 10-year yield is up 45 bps and the Bloomberg Barclays Treasury index has underperformed a position in cash by 2.7% (Chart 1). These recent developments raise two important questions. First, should investors chase or fade the back-up in Treasury yields? And second, if the sell-off does continue, how high can yields go? To answer these questions we turn to the five macro factors that drive trends in US bond yields. These factors were outlined in our “Bond Kitchen” report from last April, and are listed right here:1 Global growth Policy uncertainty The US dollar The output gap Sentiment Back In The Kitchen Global Growth Chart 2CRB Index Needs To Rebound Three global growth indicators are particularly relevant for US Treasury yields. They are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. The latter is especially useful because it updates on a daily basis. Considering the CRB index, we notice that, while it is no longer in a steep downtrend, it has also not rebounded alongside the jump in bond yields (Chart 2). This should give us pause. Continued low readings from the CRB index make it more likely that bond yields will fall back in the coming weeks. We should also note that the ratio between the CRB index and Gold is more highly correlated with the 10-year Treasury yield than the CRB index itself.2 This ratio has bounced off its lows (Chart 2, top panel), but only because Gold has come under downward pressure. With the Fed committed to maintaining an accommodative policy stance until inflation expectations are re-anchored, we expect the Gold price to remain well bid. This means that raw industrials prices must rebound to keep the ratio trending higher. The CRB/Gold ratio has bounced off its lows, but only because Gold has come under downward pressure. More encouraging than the CRB index is the Global Manufacturing PMI, which has moved off its lows during the past three months (Chart 3). The increase has been partially driven by stronger US readings (Chart 3, panel 2), but principally by a significant jump in China’s PMI (Chart 3, bottom panel). Chart 3China Pulling The Global Manufacturing PMI Higher Somewhat stronger China PMI readings should be expected, given the rebound in our China Investment Strategy’s Li Keqiang Leading Indicator – a composite measure of monetary conditions, money and credit growth (Chart 4).3 We should also expect further modest policy stimulus from China, as long as the labor market remains under pressure (Chart 4, bottom panel). Turning to the US, we have seen three very positive developments in the economic data during the past month. First, the ISM Services PMI jumped from 52.6 to 54.7 in October (Chart 5). A drop in this index to 50 or below would be consistent with a US recession, while the combination of a strong service sector and a depressed manufacturing sector is consistent with our baseline 2015/16 roadmap. This roadmap leads to an eventual rebound in the manufacturing index. Second, the ISM Manufacturing PMI rose a tad in October, but the New Export Orders component jumped significantly from 41 to 50.4 (Chart 5, panel 2). Since the global slowdown began as a non-US phenomenon, a rebound in this export component sends a strong signal that we are at an inflection point. Finally, consumer confidence rose in October following a sharp decline in September. A year-over-year decline in the consumer confidence index is a reasonably strong recession signal, but recent data suggest that this signal is fading (Chart 5, bottom panel). Chart 4Modest Stimulus In China Chart 5Three Positive Developments All in all, the global growth data have turned more positive during the past month. US indicators, in particular, are no longer sending strong recessionary signals. A rebound in the CRB Raw Industrials index would give us more confidence in the durability of the recent rise in Treasury yields. Policy Uncertainty Uncertainty about the US/China trade conflict has eased considerably during the past few weeks, as the two sides appear to be working toward a “phase 1” deal that would prevent the imposition of new tariffs and roll back some that are already in place. Heightened uncertainty about the trade war played a large role in dragging bond yields lower in 2019. This becomes apparent when you notice that survey and sentiment (aka “soft”) data about the economic outlook have been significantly worse than the actual “hard” data on US economic activity.4 It is clear that negative sentiment about the trade war has held survey data and bond yields down, even as underlying US economic activity has been solid. Less bullish dollar sentiment supports a continued uptrend in Treasury yields.  We see a continued easing of trade tensions as we head into the first half of next year. President Trump has an incentive to support the economy in an election year, given the historical record of incumbent presidents being re-elected when the economy is strong. However, if this strategy doesn’t work and Trump finds himself behind in the polls by the end of next summer, then he could decide that ramping up the trade war again is the best course of action. In other words, another spike in policy uncertainty in the second half of 2020 is possible if President Trump is trailing in the polls. The US Dollar Chart 6Dollar Sentiment Points To Higher Yields The US dollar is important for the path of US Treasury yields because it signals whether US yields are decoupling from yields in the rest of the world. In other words, if the dollar appreciates significantly alongside rising Treasury yields, then we should view those yields as increasingly out of step with the rest of the world, and thus more likely to fall back down. So far, the dollar has been relatively flat as yields have risen and bullish sentiment toward the US dollar has declined significantly (Chart 6). Less bullish dollar sentiment supports a continued uptrend in Treasury yields. But if yields do in fact continue to rise, it will be important to watch the dollar’s reaction. The Output Gap Chart 7Wage Gains Hurting Margins, Not Raising Prices Some sense of the output gap is important for forecasting bond yields. This is because the same amount of global growth will lead to more inflationary pressure and higher bond yields when the output gap is small than when it is large. The fact that the output gap is smaller now than it was in 2016 is probably the reason why the 10-year Treasury yield bottomed 10 bps above its 2016 trough this year, and why the average Treasury index yield bottomed 47 bps above its 2016 trough. We have found wage growth to be an excellent indicator of the output gap, and noted in a recent report that wage growth should continue to accelerate.5 In this vein, another crucial variable to monitor is labor compensation as a percent of national income (Chart 7). The rise in this series indicates that wage gains during the past few years have come at the expense of corporate profit margins, and have not been passed through to higher consumer prices. If this series proves to have a lot more cyclical upside, then it could be some time before wage acceleration translates to higher inflation. Sentiment Chart 8Surprise Index Says Sentiment Is Neutral The final factor we consider when forecasting US Treasury yields is sentiment. We have found that the Economic Surprise Index is the single best measure of aggregate market sentiment. That is, when the Surprise index reaches a positive or negative extreme, it usually means that sentiment is too positive or too negative, and will mean-revert in the months ahead. Also, we have observed a strong correlation between the Surprise index and changes in Treasury yields (Chart 8). At present, the Surprise index is roughly neutral, and therefore does not send a strong signal about where sentiment might push bond yields during the next few months. Investment Conclusions To summarize, the outlook from our five macro factors suggests that Treasury yields will rise further in the coming months. Global growth indicators are showing tentative signs of bottoming, and should rise to levels more consistent with the “hard” economic data as policy uncertainty continues to wane. The fact that the US economic data look less recessionary than they did one month ago makes us more confident that our global indicators will rebound. Chart 9A Clear Path To 2.5% We would become concerned about a renewed downtick in yields if the CRB Raw Industrials index fails to rebound, or if the dollar strengthens significantly in the coming weeks. At the beginning of this report, we asked how high Treasury yields can go if the global growth rebound proves durable. To answer that question we refer to current estimates of the long-run neutral fed funds rate. The FOMC’s median estimate of the long-run neutral fed funds rate is 2.5% and the median estimate from the New York Fed’s Survey of Market Participants is 2.48%, with an interquartile range of 2.25% - 2.5%. If recessionary fears move to the back burner, it would be logical for long-dated yields to converge toward those levels. That is in fact what happened in recent years, with the 5-year/5-year forward Treasury yield peaking several times at levels close to the Fed’s median neutral rate estimate (Chart 9). With this in mind, we see a clear path to 2.5% on the 5-year/5-year forward Treasury yield, with the 10-year yield reaching similar levels since the 5/10 Treasury slope is likely to remain flat (Chart 9, bottom panel). For yields to eventually move above 2.5%, the market would have to re-consider its outlook for the long-run neutral fed funds rate. We discussed what factors to monitor in this regard in a recent report.6 Bottom Line: Treasury yields have moved significantly higher in recent weeks, but a survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Checking In On The Credit Cycle In previous reports, we mentioned that three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health Monetary conditions Valuation We last presented a detailed examination of these factors in a report from mid-September, concluding that accommodative monetary conditions will support corporate bond excess returns, despite deteriorating balance sheet health.7 Three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health, monetary conditions,and valuation. But since then, C&I lending standards – an important indicator of monetary conditions – moved into “net tightening” territory for the third quarter of 2019 (Chart 10). Tightening C&I lending standards, if they persist, would put significant upward pressure on corporate defaults and credit spreads. Chart 10Credit Cycle Checklist: Monetary Conditions While the recent move in lending standards is concerning, we expect it to reverse in the near future. The yield curve, another indicator of monetary conditions, has steepened in recent months, suggesting that conditions are becoming more accommodative. Also, loan officers reported that the terms on C&I loans continued to ease in Q3, even as overall standards tightened (Chart 10, panel 3). Most importantly, inflation expectations remain extremely low (Chart 10, bottom panel). This gives the Fed every incentive to maintain accommodative monetary conditions. This should give lenders the confidence to ease lending standards, leading to tight credit spreads and a low corporate default rate. Bottom Line: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. Downgrade Investment Grade Corporates To Neutral Last week, we downgraded our recommended allocation to investment grade corporate bonds from overweight to neutral.8 We maintain a positive view of the credit cycle, and expect that corporate bonds will continue to outperform Treasuries. However, investment grade corporate spreads no longer provide adequate compensation for their level of risk. We maintain an overweight allocation to high-yield corporates, where spreads remain attractive. Chart 11 shows that investment grade corporate spreads have tightened somewhat in recent months, but that they remain well above the tights seen in early 2018. However, the chart also shows that average index duration has increased considerably this year. All else equal, higher index duration justifies a wider spread. In contrast, notice that high-yield index duration fell this year (Chart 11, bottom panel). This is because high-yield bonds usually carry embedded call options, making them negatively convex. All else equal, lower index duration makes the spread offered by the high-yield index more attractive. Because changes in spread and duration are both important, we prefer to use the 12-month breakeven spread as our main valuation tool. This measure is the spread widening required on a 12-month investment horizon to underperform a duration-matched position in Treasuries. It can be approximated by dividing the option-adjusted spread by duration. Chart 12 shows investment grade 12-month breakeven spreads as a percentile rank since 1995. The overall message is that spreads have rarely been lower. Chart 11Higher Durations Makes IG Spreads Look Too Tight Chart 12Investment Grade Corporate Spreads Have Rarely Been Lower Finally, we can also recognize that spreads tend to be tight in the middle and late stages of the credit cycle. In the current environment, that means we should expect spreads to be near the bottom of their historical ranges. To control for this fact, we re-calculate our breakeven spread percentile ranks using only mid-cycle periods when the slope of the yield curve is between 0 bps and 50 bps. We can then back-out spread targets for each credit tier based on the median 12-month breakeven spreads seen in similar macro environments. Chart 13 shows that spreads for all investment grade credit tiers have moved below our targets. High-yield spreads are not shown, but they remain well above target levels.9 Chart 13Spreads For All IG Credit Tiers Are Below Target In place of investment grade corporates, which have become expensive, we recommend upgrading Agency MBS. MBS now offer expected returns that are comparable with corporate bonds rated A or higher, with considerably less risk.10 Bottom Line: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 For details on why the ratio between the CRB Raw Industrials index and Gold tracks the 10-year Treasury yield please see US Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com 3 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 4 For more details on the divergence between “soft” and “hard” data please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Portfolio Allocation Summary, “The Fed Will Stay Supportive”, dated November 5, 2019, available at usbs.bcaresearch.com 9 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 10 For more details on the positive outlook for MBS please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The correlation between oil and petrocurrencies has shifted in recent years. It no longer makes sense going long petrocurrencies versus the US dollar blindly. One of the reasons has been the impressive and prominent output from US shale. We are currently long a basket of petrocurrencies versus the euro, but intend to shift this trade towards a short USD position on more visible signs of a breakdown in the US dollar. Go short CAD/NOK for a trade. Feature Chart I-1Oil And Petrocurrencies Have Diverged Since the middle of the last decade, one of the most perplexing disconnects has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices more than doubled, but the petrocurrency basket has underperformed by a whopping 110% versus the US dollar. This has been a very perplexing result that has surprised many investors on what was traditionally a very sound correlation (Chart I-1).  In general, an increase in oil prices usually implies rising terms of trade, which should increase the fair value of a currency. Throughout our modeling exercises, terms of trade were uncovered as what mattered the most for commodity currencies in general, and petrocurrencies in particular. In theory, this makes sense, given the improvement in balance-of-payment dynamics (that tend to be observed with a lag) and the ability for increased government spending, allowing a resident central bank to tighten monetary policy. In the case of Canada and Norway, petroleum represents over 20% and 50% of total exports. For Saudi Arabia, Iran or Venezuela, this number is much higher. Therefore, it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Historically, getting the price of oil right was usually the most important step in any petrocurrency forecast, but it has now become a necessary but not sufficient condition. Oil Demand Should Recover We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. Ergo the trade slowdown brought a lot of freighters, bulk ships, large crude carriers and heavy trucks to a halt (Chart I-2). Chart I-2Oil Demand Has Been Weak Part of the slowdown in global demand is being reflected through elevated inventories. However, part of the inventory building has also been a function of refinery maintenance (Chart I-3). Chinese oil imports continue to hold up well, and should easier financial conditions put a floor on the manufacturing cycle, overall consumption will follow suit (Chart I-4). Chart I-3Oil Inventories Are Elevated Chart I-4China Oil Imports Holding Up The increase in oil demand will be on the back of two positive supply-side developments. First, OPEC spare capacity is only at 2%. This means that any rebound in oil demand in the order of 1.5%-2% (our base case), will seriously begin to bump up against supply-side constraints – especially in the face of OPEC production discipline. Second, unplanned outages wiped out about 1.5% of supply in 2018, and should this occur again as oil demand recovers, it will nudge the oil market dangerously close to a negative supply shock (Chart I-5). Chart I-5Opec Spare Capacity Is Low Bottom Line: A recovery in the global manufacturing sector will help revive oil demand. This should be positive for oil prices in general. A Necessary But Not Sufficient Condition Rising oil prices are bullish for petrocurrencies, but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. As the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency. In 2010, only about 6% of global crude output came from the US. Collectively, Canada, Norway and Mexico shared about 10% of the oil market. Meanwhile, OPEC’s market share sat just north of 40%. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart I-6). Chart I-6US Has Grabbed Oil Production Market Share This explains why the positive correlation between petrocurrencies and oil has been gradually eroded as the US economy has become less and less of an oil importer. Put another way, rising oil prices benefit the US industrial base much more than in the past, while the benefits for countries like Canada and Mexico are slowly fading. Meanwhile, falling production in Iran, Venezuela, and even Angola has been a net boon for US production and the dollar.  In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time US production was about to take off (Chart I-7). Since then, that correlation has fallen from around 0.9 to around 0.2. At the same time, the DXY dollar index is on its way to becoming positively correlated with oil as the US becomes a net energy exporter. Chart I-7Falling Correlation Between Petrocurrencies And The US Dollar Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian peso. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Oil Consumers Versus Producers Our strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar downleg. We are long an oil currency basket versus the euro, but intend to make the switch once our momentum indicators for the dollar decisively break lower. With bond yields having already made a powerful downward adjustment, the valve for financial conditions to get any looser could easily be via the US dollar (Chart I-8). A loss of global market share has hurt the oil sensitivity of many petrocurrencies. The second strategy is to be long a basket of oil producers versus oil consumers. Chart I-9 shows that a currency basket of oil producers versus consumers has both had a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. It is also notable that the correlation has strengthened as that between petrocurrencies and the US dollar has weakened. Chart I-8The Dollar As An Arbiter Of Growth Chart I-9Buy Oil Producers Versus Oil Consumers Sell CAD/NOK The Norges Bank has been quite hawkish in spite of the dovish tilt by most other central banks. As such, the underperformance of the Norwegian krone, especially versus the euro, has been quite perplexing in the face of diverging monetary policies (Chart I-10). Our bias is that speculators have been using the thinly traded krone to play USD upside, but that momentum is now fading. The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence, and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher. A weak exchange rate will also anchor inflation expectations (Chart I-11). Chart I-10Diverging Monetary ##br##Policies Chart I-11A Weak Exchange Rate Will Anchor Inflation Expectations Higher The underperformance of the Norwegian krone has mirrored that of global oil and gas stocks. Perhaps sentiment towards the environment and climate change has been pushing investor flows out of these markets, but given the central role oil plays in the global economy, we may have reached the point of capitulation (Chart I-12). Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts. Our recommendation is that NOK long positions should initially be played via selling the CAD, as an indirect way to express USD shorts (Chart I-13). The CAD/NOK briefly punched through the 7.1 level in October but is now seeing a powerful reversal. Our intermediate-term indicators also suggest the next move is likely lower. The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart I-14) Chart I-12ESG And Global Divestments Chart I-13NOK Will Outperform CAD (I) Chart I-14NOK Will Outperform CAD (II) Bottom Line: Go short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. 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 strong:  The labor market remains tight: nonfarm payrolls increased by 128K in October, well above expectations of 89K. Average hourly earnings continue to grow by 3% year-on-year. Unit labor costs grew by 3.6% year-on-year in Q3. The ISM manufacturing PMI increased to 48.3 from 47.8 in October. The non-manufacturing PMI soared to 54.7 from 52.6 in October, well above expectations. The trade balance narrowed by $2.5 billion to $52.5 billion in September. The DXY index appreciated by 0.8% this week. ISM PMI data points to improvements in both manufacturing and services sectors, mainly supported by production, new orders, and the employment components. It will be interesting to monitor if this signals an improvement in the global manufacturing cycle, or is a US-centric issue. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Markit manufacturing PMI slightly increased to 45.9 from 45.7 in October. The services PMI also improved to 52.2 from 51.8. The Sentix confidence index increased to -4.5 from -16.8 in November.  Retail sales grew by 3.1% year-on-year in September, an improvement from the 2.7% yearly growth rate in the previous month. EUR/USD fell by 0.8% this week. On Monday, Christine Lagarde, the former managing director of the IMF, gave her first speech as the new ECB president where she urged Europe to overcome self-doubt, aiming to boost investor and business confidence in the euro area. However, no comments were given regarding ECB monetary policy. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Vehicle sales shrank by 26.4% year-on-year in October. The monetary base grew by 3.1% year-on-year in October. The services PMI plunged to 49.7 from 52.8 in October. The Japanese yen depreciated by 1% against the US dollar this week. We remain short USD/JPY given global economic uncertainties and domestic deflationary tailwinds. Should the global economy pick up early next year, the yen could still remain bid against the USD, allowing investors time to rotate their short USD/JPY bets. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased to 49.6 from 48.3 in October. Services PMI increased to 50 from 49.5 in October. Retail sales increased by 0.1% year-on-year in October, compared to a contraction of 1.7% in the previous month. Halifax house prices grew by 0.9% year-on-year in October. GBP/USD depreciated by 1% this week. On Thursday, the BoE decided to leave its interest rate unchanged at the current level of 0.75%. However, unlike a unanimous decision as in previous policy meetings this year, two BoE officials unexpectedly voted to lower interest rates amid signs of deeper economic slowdown and entrenched Brexit chaos. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Retail sales grew modestly by 0.2% month-on-month in September. The Commonwealth composite PMI fell slightly to 50 from 50.7 in October. The services PMI also fell to 50.1 from 50.8. The trade balance increased by A$1.3 billion to A$7.2 billion in September. Both exports and imports grew by 3% month-on-month in September. The Australian dollar has been volatile against the US dollar, but returned flat this week. The RBA has left its interest rate unchanged this Monday, as widely expected. We remain positive on the Australian dollar and went long AUD/CAD last week, which is currently 0.3% in the money. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: The participation rate increased marginally to 70.4% from a downward-revised 70.3% in Q3. The labor cost index increased by 2.3% year-on-year in Q3. The unemployment rate however, climbed to 4.2% from 3.9%, higher than expectations of a rise to 4.1%. The kiwi fell by 1.4% against the US dollar, making it the worst performing G-10 currency this week. Despite the rise of the unemployment rate in Q3, the under-utilization rate, a broad measure of labor market spare capacity has fallen to the lowest level in over 11 years, as suggested by the manager of Statistics New Zealand, Paul Pascoe. That said, we remain underweight the kiwi given it will likely lag other commodity currencies in a global growth upswing. We will change this view if New Zealand terms of trade start to inflect meaningfully higher. Stay with our long AUD/NZD and SEK/NZD positions. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The Markit manufacturing PMI was little changed at 51.2 in October. The trade deficit narrowed marginally from C$1.24 billion to C$0.98 billion in September. Exports and imports both fell in September. Ivey PMI fell to 48.2 from 48.7 in October. USD/CAD increased by 0.3% this week. The recent uptick in oil prices support the Canadian dollar, but the loonie will likely underperform other petrocurrencies. We remain bullish on the oil prices, however, spreads will likely continue to move against the Western Canadian Select blend. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline CPI fell below 0 at -0.3% year-on-year for the first time over the past 3 years in October. On a month-on-month basis, it contracted by 0.2%. Real retail sales grew by 0.9% year-on-year in September. PMI improved to 49.4 from 44.6 in October. FX reserves were little changed at CHF 779 billion in October. The Swiss franc fell by 0.9% against the US dollar this week. Faced with deflationary pressures, the SNB will likely to use its currency as a weapon to stimulate the economy and exit deflation. This will favor long EUR/CHF positions. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Industrial production contracted by 8.1% year-on-year in September, mainly caused by the slowdown in extraction and related services. On the positive side, manufacturing output grew by 2.9% year-on-year. The manufacturing output of ships, boats, and oil platforms in particular, grew by 26.2% year-on-year in September. The Norwegian krone appreciated by 0.3% against the US dollar this week, despite the broad dollar strength. The WTI crude oil price increased by nearly 6% this week, which is a tailwind for petrocurrencies. We maintain a pro-cyclical stance and expect oil prices to increase further. The global growth recovery and a weaker US dollar should all boost the oil demand, and lift the Norwegian krone. Please refer to our front section this week for more detailed analysis on the NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: The manufacturing PMI fell marginally to 46 from 46.3 in October. Industrial production growth slowed to 0.9% from 2.1% year-on-year in September. Manufacturing new orders contracted by 1.5% year-on-year in September. The Swedish krona has been flat against the USD this week. The PMI components of new orders, industrial production, and employment all continued to fall. On the positive side, the export component increased marginally. We expect the cheap krona to help improve the trade dynamics in Sweden and put a floor under the krona. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of  payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit   Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially   BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1  As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2   Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market.   Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system.    Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1    BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves  are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2   Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.

  Highlights While the Caixin PMI is pointing to improving economic conditions, other data series still reflect weak growth. China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. The failure of Chinese stocks to significantly outperform the global benchmark and the continued underperformance of cyclical stocks underscore the near-term risks to equities if this month’s trade & manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the data remains mixed: the strength in the October Caixin PMI and the September pickup in electricity production are positive signs, but other important datapoints still point to weak conditions. We continue to expect that China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. We continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks have rallied in absolute terms over the past month in response to greatly increased odds of a trade truce between China and the US, but have failed to outperform the global benchmark. This, in combination with the continued underperformance of cyclical stocks, suggests that hard evidence of an economic improvement in China will be required before Chinese stocks begin to rise in relative terms. The risk of near-term underperformance is still present, especially if October’s hard trade and manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1Not Yet A Clear Change In Trend The Bloomberg Li Keqiang index (LKI) ticked up in September, led by an improvement in electricity production. An improvement in the LKI in lockstep with a rising Caixin manufacturing PMI (discussed below) raises the odds that the Chinese economy may be bottoming earlier than we expect, but for now only modestly so. Chinese economic data is highly volatile, and Chart 1 shows that the improvement in the LKI is very muted when shown as a 3-month moving average. In addition, a slight improvement also occurred earlier this year, but proved to be a false signal. All told, for now we continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Our leading indicator for the LKI was essentially flat in September on a smoothed basis, with sequential declines in M3 growth and the credit components of the indicator offsetting improvements in monetary conditions and M2. From a big picture perspective, the story of our LKI leading indicator remains unchanged: it continues to trend higher, at a much shallower pace than has been the case during previous easing cycles. The uptrend is the basis of our forecast that China’s growth will soon bottom, but the uncharacteristically shallow nature of the rise suggests that the eventual recovery will be modest. On a smoothed basis, Chinese residential floor space sold improved again in September, following a very significant rise in August. Over the past 12-18 months, we had emphasized that the double-digit pace of growth in China’s housing starts was unsustainable because it had entirely decoupled from the trend in sales (which have reliably led construction activity over the past decade). This gap disappeared over the summer due to a significant slowdown in starts, which is what we predicted would occur. However, the recent acceleration in floor space sold represents a legitimate fundamental improvement in the housing market, that for now is difficult to attribute to the recent drivers of housing demand (Chart 2).1 Still, investors should continue to watch China’s housing demand data closely over the coming few months, for further signs of a potential re-acceleration in housing construction. Investors need to see meaningful sequential improvements in China’s October trade and manufacturing data. The October improvement in China’s Caixin PMI was quite notable, as it appears to confirm the full one-point rise in the index that occurred in September and suggests that manufacturing in China’s private-sector is now durably expanding. Still, conflicting signals remain: the official PMI fell in October and remains below 50, and the significant September improvement in the Caixin PMI was not corroborated by an improvement in producer prices or nominal import growth (Chart 3). As PMIs are simply timely coincident indicators that do not generally have leading properties, investors will need to see meaningful sequential improvements in China’s October trade and manufacturing data in order to have confidence that the Caixin PMI improvement is not a false signal. Chart 2It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand Chart 3If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon Chinese stocks have rallied 6-7% over the past month in absolute terms, but have modestly underperformed global equities. The rally in global stock prices has occurred largely in response to the mid-October announcement of a trade truce between China and the US. The failure of Chinese stocks to outperform during this period suggests hard evidence of an economic improvement in China will be required before Chinese stocks begin to outpace their global peers. At the regional equity level, the other notable development over the past month has been the continued outperformance of the MSCI Taiwan Index versus the global benchmark. Taiwan’s outperformance has been boosted by a rising TWD versus the dollar, but Taiwanese stocks have also outperformed in local currency terms. Taiwan province is highly exposed to global trade, and it is not surprising that equities have reacted positively to the prospect of a trade truce between the US and China. Further meaningful outperformance, however, will likely require a re-acceleration in Taiwanese exports, as export growth has merely halted its contraction (Chart 4). Within China’s investable equity market, cyclicals have underperformed defensives over the past month after having rallied significantly from late-August to mid-September (Chart 5). We noted in our October 30 Special Report that these cyclical sectors have historically been positively correlated with pro-cyclical macroeconomic and equity market variables,2 and their underperformance versus defensives is thus consistent with the failure of Chinese stocks in the aggregate to outperform global equities over the past month. In both cases, outperformance likely requires hard evidence of an upturn in China’s business cycle. Chart 4Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Chart 5Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks We do not take the rise in Chinese government bond yields as necessarily indicative of an imminent breakout in relative equity performance. Chart 6Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese 10-year government bond yields have risen roughly 15bps over the past month, and are now 30bps off of their mid-August low. Many market participants view Chinese government bond yields as a leading growth barometer, but 10-year yields have actually lagged Chinese investable stock performance over the past two years (Chart 6). As such, we do not take the rise in yields as necessarily indicative of an imminent breakout in relative equity performance. Chinese onshore corporate bond spreads have declined over the past month as government bond yields have been rising, continuing a pattern of negative correlation between the two that has prevailed since early-2018. A negative correlation between yields and corporate bond spreads is a normal relationship, and it suggests that spreads may narrow over the coming year if the Chinese economy bottoms in Q1, as we expect. Spreads remain elevated despite the substantial easing in monetary conditions that occurred last year, due to persistent concerns about rising onshore defaults. While we acknowledge that defaults are indeed occurring, we have argued on several occasions that the pace of defaults would have to be much faster in order for current spreads to be justified.3 We continue to recommend a long RMB-denominated position in China’s onshore corporate bond market. The RMB has appreciated over the past month in response to news of a likely trade truce between the US and China, with most of the rise having occurred versus the US dollar. USD-CNY is likely to sustainably trade below the 7 mark in a trade truce scenario, but how much further downside is possible in the near-term absent a re-acceleration in Chinese economic activity remains an open question. With the Fed very likely on hold for the next year, stronger than expected economic growth in China would likely catalyze a persistent selloff in USD-CNY barring a re-emergence of the Sino-US trade war. This, however, is not our base-case view, meaning that we expect modest post-deal strength in the RMB.   Jonathan LaBerge, CFA Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1. Please see China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 2. Please see China Investment Strategy Weekly Report, “A Guide To Chinese Investable Equity Sector Performance,” dated October 30, 2019. 3. Please see China Investment Strategy Weekly Reports, “A Shaky Ladder,” dated June 13, 2018, "Investing In The Middle Of A Trade War,” dated September 19, 2018 and "2019 Key Views: Four Themes For China In The Coming Year,” dated December 5, 2018. Cyclical Investment Stance Equity Sector Recommendations