Currencies

Highlights The rising spectre of global market volatility has reignited interest in the Swiss franc. In the current geopolitical game of brinksmanship between the U.S. and China, the risk of miscalculation is high, suggesting it pays to have insurance in place. The large net short positioning in the Swiss franc and cheap valuation make it attractive from a contrarian standpoint. That said, the Swiss National Bank (SNB) is unlikely to sit and watch the CHF catapult to new highs. We expect currency intervention will be actively and aggressively used as a policy tool. Over the longer term, high domestic savings, rising productivity and a chronic current account surplus are underlying sources of support for the Swiss franc. Hold on to CHF/NZD positions recommended on April 26. We expect the unofficial floor of EUR/CHF 1.08-1.12 to hold in the near term but will respect our stop-loss at 1.11 if it is breached. Feature For most of the past decade, the Swiss franc has tended to be a dormant currency, interspersed by short bouts of intense volatility. For example, the USD/CHF is sitting today exactly where it was in early 2008, yet during this period the franc has seen wild gyrations that have lasted anywhere from just a few days to a few months. Outside of these swings, both USD/CHF and EUR/CHF have been mostly stable (Chart I-1). Chart I-1On The Verge Of A Big Move? The first bout of volatility occurred during the Great Financial Crisis, when the franc appreciated by 13% versus the euro, from July to October 2008. The second adjustment was marked by the European debt crisis, with the drop in the euro putting tremendous upward pressure on the franc. From the beginning of 2010 until September 2011 (when the SNB eventually put a currency floor in place), the euro plummeted by almost 35% versus the franc. More importantly, two-thirds of this adjustment occurred in the short few months before the SNB took action. The most recent adjustment in the franc has been the most interesting, because it was the central bank itself – not market forces – that triggered volatility in the exchange rate. In January 2015, the SNB decided to abandon the EUR/CHF 1.20 floor. The euro instantaneously cratered by about 30% versus the franc before retracing half of those losses a few days after. Since then, the EUR/CHF has been slowly creeping back towards the levels that prevailed before the floor was abandoned. The unifying theme across all three episodes is that the franc has tended to stage big moves near market riot points. Over the past week, the Swiss franc has emerged as one of the best-performing currencies amid the rising spectre of global market volatility (Chart I-2). This brings forward a few interesting questions. Will the SNB abandon the unofficial floor of EUR/CHF 1.08-1.12, or does it have an incentive to vigorously defend the currency? Should market volatility intensify from current levels, what trading opportunities are available to investors? Finally, what is the medium- and long-term outlook for the Swiss franc? Chart I-2The Franc Loves Volatility The Case For An Unofficial Cap The irony of the Swiss currency cap is that both its inception in 2011 and eventual demise in 2015 were rooted in deep external deflationary shocks, but the rationale behind the SNB’s moves in both episodes was vastly different. Back in 2011, Switzerland was rapidly stepping back into deflation, having just barely escaped it a year earlier. More importantly, this was driven by tradeable goods prices, given the franc’s rampant appreciation. At its nadir in 2011, goods prices were deflating by 3%, and rapidly dragging down inflation expectations with them. The SNB quickly realized that for a small, open economy like Switzerland, the exchange rate becomes incrementally important if deflation is entrenched (Chart I-3). Ergo, sitting and watching the trade-weighted Swiss franc continue to appreciate, especially given the euro was in a cascading downdraft, appeared to be a recipe for disaster. The stakes were especially high, given recent memory of the Great Recession. The cap worked like a charm, and the authorities could not have hoped for a better result. Inflation expectations staged a V-shaped recovery, along with headline inflation. The economy entered into a meaningful economic rebound, with the PMI swiftly rising above 50 and real GDP growth accelerating from near standstill to a 2.5% pace by 2014. This set the stage for a stock market rally that more than doubled the SMI index, nudging it back to its pre-crisis highs. The SNB quickly realized that for a small, open economy like Switzerland, the exchange rate often dictates the trend in domestic inflation. Since then, the inflation dynamics have improved even further, reinforcing the view that the SNB continues to manage the currency, even though the EUR/CHF floor was abandoned over four years ago. Inflation has risen almost uninterruptedly since it bottomed in 2015 (Chart I-4) – a feat that has not been replicated in major economies like the U.S. or euro area. During the same period, the EUR/CHF has trended higher, stabilizing during bouts of EUR/USD weakness but strengthening alongside gains in the euro. This has cheapened the trade-weighted franc, buffeting consumer prices. Chart I-3Exchange Rates Affect Tradeable Goods' Prices Chart I-4The SNB Has Done A Good ##br##Job So Far Our bias is that the whisper floor of 1.08-1.12 for EUR/CHF will continue to persist until the Swiss economy decisively exits deflation. In its latest monetary policy report, the SNB lowered its inflation target for 2019 and 2020 from 0.5% to 0.3% and 1% to 0.6% respectively. Meanwhile, three key factors suggest the inflation rate will continue to be anchored at low levels in the near term: Global trade has slowed meaningfully since the onset of 2018 and continues to drift downward. Given the complex nature of Swiss exports and their high-ranking in the value chain, they have been largely insulated from the slowdown (Chart I-5). It also helps that exporters have been able to cut prices to maintain volume sales. However, there is a natural limit as to how much exporters can cut prices to maintain demand, or how long exports can be insulated from a global slowdown, let alone a trade war. Falling exports will be a renewed powerful deflationary pulse for the domestic economy. While the franc has cheapened, our models suggest it still remains 5% overvalued versus the euro (Chart I-6). This explains in part why import prices remain under downward pressure, since it is just the mirror image of an expensive currency. In a world of still-low inflation, any adjustment in the real exchange rate can only occur very slowly. Swiss prices are rising at a 0.7% annual rate, while eurozone prices are rising at a 1.7% clip. This suggests it will take about five years just for the franc to close its overvaluation gap versus the euro. This suggests the SNB will be loath to tolerate any knee-jerk appreciation in the franc. Chart I-5Swiss Exports At Risk From A Trade War Chart I-6EUR/CHF Is Still 5% Cheap While the output gap has closed, it remains well below levels that have previously begun to generate meaningful inflationary pressures in the domestic economy. Domestic retail sales remain weak on the back of tepid wage growth. While the unemployment rate is at 2.4%, it usually takes the unemployment rate falling below 1% before it begins to generate any significant inflationary pressures. This is unlikely to happen over the next six to nine months. The Swiss labor market is extremely flexible and fluid, allowing for tremendous efficiency. Part-time employment continues to dominate job gains, meaning the need for precautionary savings will continue to restrain spending. Chart I-7Money Supply Growth Has Converged To GDP Growth Interestingly, the SNB has not had to ramp up its balance sheet significantly in recent years. Part of the reason is that the slowdown in global trade eased natural demand for francs, which meant the SNB was no longer accumulating foreign exchange reserves at a rampant pace. More importantly, the SNB has used the global slowdown to drain excess liquidity from the system and somewhat renormalize policy. Back in 2011 when the SNB put the cap in place, there was an explosion in domestic liquidity, with broad money supply rising at a 10% pace. As panicked investors were fleeing the European periphery, there were large inflows into the Swiss economy and into the haven of government bonds, driving up the franc in the process. The same pattern was repeated again in 2016 after the U.K. referendum to leave the EU. This time around, a lack of significant EU tail risks on the near-term horizon have curtailed safe-haven flows into the franc. This has allowed Swiss money supply growth to converge towards nominal GDP growth, effectively sterilizing excess liquidity (Chart I-7). The message from SNB Central Bank Chair Thomas Jordan has been very clear: Interest rates could be lowered further, along with powerful intervention in the foreign exchange market if necessary. This suggests that in the near term the preference for the SNB is for a stable exchange rate. The issue is that market forces have occasionally dictated otherwise, especially during riot points. With the S&P 500 off its highs, corporate spreads both in the U.S. and euro area inching higher, the VIX in an uptrend and government bond yields falling, we may be approaching such a point. Lessons From The 1990s And 2015 The natural questions that follow are that if the cap worked so perfectly, then why was it scrapped in the first place? And why not explicitly put it back on, given the rising specter of global asset volatility and Swiss franc strength? After all, if the risk for Switzerland is that it could abruptly step back into deflation, then the SNB can use the franc as a potent weapon to ease domestic financial conditions. Capping the franc at a cheap level to the euro, say back at 1.20, could be exactly what the doctor prescribed. The reality is that there are both political and economic constraints to such a commitment. While the decision to scrap the EUR/CHF floor was a puzzle to most investors back in 2015, a post-mortem analysis suggests the reasoning in hindsight was rather obvious. Back in 2015, the world economy was entering into a manufacturing recession as China closed off the credit spigots. This was particular acute in the Eurozone, which had just exited a double-dip recession but was facing credit growth falling at a 7% pace. Enter quantitative easing.  The deflationary backdrop back then had already led to an explosion of high-powered money as foreigners flocked into Swiss assets. Foreign exchange reserves were rapidly outpacing the monetary base and quickly closing in on nominal GDP (Chart I-8). The risk of course is that if surging money and credit growth cannot fuel consumer price inflation, it can only stimulate an asset price boom. A floor to a currency about to ride a wave of large-scale monetary stimulus was disconcerting to even the most Keynesian of Swiss central bankers. A floor to a currency about to ride a wave of large-scale monetary stimulus was disconcerting to even the most Keynesian of Swiss central bankers. Meanwhile, there had already been a rising chorus of discontent among right-wing politicians in 2014, specifically those within the Swiss People’s Party (SVP) who wanted the central bank to stop buying foreign currencies and significantly lift its gold holdings instead. As early as October of 2014, opinion polls suggested that support for the proposal was at 44%, with only 39% of Swiss citizens against.1 Memories from the 1990s asset burst in Switzerland were front and center among SVP members. The Plaza Accord had led to the proliferation of carry trades into Switzerland as the U.S. dollar fell. This was supercharged by strong migration into Switzerland ahead of the fall of the Berlin Wall. All of this lit a fire under the real estate market. The SNB was eventually forced to raise interest rates from 3.5% in 1998 to 9% in 1992, transforming a real estate bull market into a 20-year bust (Chart I-9). With the SVP currently ahead in opinion polls ahead of the October 2019 elections, this is likely to remain a constraint Chart I-8Still Lots Of High-Powered Money In Switzerland Chart I-9Macro-Prudential Measures Have Stymied A Housing Bubble Economically, the SNB has to walk a fine line between a predominantly deflationary backdrop in Switzerland but a rising debt-to-GDP ratio that pins it among the highest in the G10 (Chart I-10). Too little stimulus, and the economy runs the risk of entering a debt-deflation spiral, as inflation expectations continue to be anchored strongly to the downside. Too much stimulus, and the result will be a build up of imbalances, leading to an eventual bust. This dilemma was the “raison d’ être” of the Swiss currency cap in 2011, but let to its eventual demise in 2015. Chart I-10The Swiss Have Lots Of Debt A final thought about the cap: It is different from a peg in that the former allows the franc to depreciate versus the euro, while the latter does not. This makes the cap an asymmetric mechanism: Only when the CHF is under upward pressure will the cap act as a QE mechanism, because the SNB has to buy euros while selling Swiss francs. Should the franc weaken against the euro, the SNB does not have to intervene, hence its balance sheet stops expanding and QE ends. The key risk is that the euro drops substantially, inviting speculation back into the Swiss economy. This risk is clearly unpalatable for both Swiss politicians and the SNB, which is why two-way asymmetry was reintroduced into the system. Trading Dynamics As A Safe Haven Switzerland ticks off all the characteristics of a safe-haven currency. Its large net international investment position of 125% of GDP generates huge income inflows. Meanwhile, rising productivity over the years has led to a structural surplus in its trading balance and a rising fair value for the currency. Consequently, the franc has tended to have an upward bias over the years, supercharged during periods of risk aversion (Chart I-11). Switzerland ticks off all the characteristics of a safe-haven currency. During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond with periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged positions become victim to short-covering flows. Given the negative yield from hedging trades funded in Swiss francs (Chart I-12), it is fair to assume a pronounced flight-to-safety will cause a knee-jerk appreciation in the franc, like in past episodes. Chart I-11The "Curse" Of The##br## SNB Chart I-12Hedging Against Franc Strength Is Expensive This is especially true, since the U.S. tax reforms have already driven foreign affiliates in Switzerland to liquidate investments (mostly real estate) and repatriate those funds back into Treasurys. Foreign direct investment in Switzerland is falling at a rate of 15% of GDP, causing the basic balance to hit -4% of GDP. These FDI outflows are unlikely to remain a headwind for the franc going forward, assuming the tax benefit was a one-time deal. Instead, a favorable balance-of-payments backdrop will continue to be a key underpinning behind the strong franc (Chart I-13). Chart I-13A One-Time Adjustment In The Basic Balance The message is that during rising periods of risk aversion, like now, speculators should accumulate francs as a portfolio hedge. We continue to favour the CHF/NZD, recommended on April 26. Aggressive investors can also sell the USD/CHF. Investment Conclusions Our long-term fair value models suggest the Swiss franc is currently cheap (Chart I-14). This makes it attractive both on a short- and longer-term basis versus a basket of currencies. The exception is versus the euro, given the EUR/CHF is still undervalued by 5%. Froth in the housing market has been eliminated. Stricter policies toward immigration, along with macro-prudential measures, such as a cap on second homes and stricter lending standards, have helped (Chart I-15). Meanwhile, the surprise move by the SNB to abandon the EUR/CHF floor has rebalanced the market. Back then, Swiss real estate became more expensive for investors in the euro area who used the SNB put to speculate on properties in Zurich and Geneva. Demand for Swiss real estate has largely decreased since then, eliminating this key source of risk for the SNB (Chart I-16) Chart I-14The Swiss Franc Is Cheap By Some Measures Chart I-15The Swiss People's Party ##br##Had Its Way Our bias is that over the next few years, the Swiss franc will be more of a dormant currency, gently appreciating towards its fair value but periodically interspersed by bouts of intense volatility. Interestingly, we may be entering such a riot point. German bund yields fell below Japanese levels this week. Historically, a falling bund yield has been a bad omen for EUR/CHF.  We will respect our 1.11 stop loss on long EUR/CHF if breached (Chart I-17). Chart I-16The SNB Had Its Way Chart I-17Where Next For Bund Yields?   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see www.reuters.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the U.S. have been positive: Headline inflation and core inflation increased to 2% and 2.1% year-on-year respectively in April. NFIB business optimism index increased to 103.5 in April. NY Empire State Manufacturing index increased to 17.8 in May. Retail sales fell by 0.2% month-on-month in April, but the Redbook retail sales clocked in a solid 5.4% growth year-on-year. Industrial production decreased by 0.5% month-on-month in April, but is still growing at 0.9% year-on-year. On the housing market front, MBA mortgage applications contracted by 0.6% in May. NAHB housing market index increased to 66 in May. Housing starts increased by 5.7% to 1.24 million month-on-month in April. Building permits increased by 0.6% to 1.3 million in April. DXY index increased by 0.4% this week. U.S. and Chinese negotiators failed to reach an agreement regarding tariffs. The increased tariffs on Chinese goods was followed by the inevitable retaliation by China this Monday. As the market gauges the net impact of the tariff from both sides, volatility will prevail. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been weaker-than-expected: Industrial production in the euro area fell by 0.6% year-on-year in March. The euro area ZEW economic sentiment fell to -1.6 in May. The German ZEW economic sentiment fell to -2.1 in May, while current situation improved to 8.2. Euro area GDP growth came in line at 1.2% year-on-year in Q1. German GDP growth increased to 0.4% quarter-on-quarter in Q1, while on a year-on-year measure, the growth rate fell from 0.9% to 0.6%. Trade balance in the euro area fell to 17.9 billion euros in March. German harmonized consumer price inflation was unchanged at 2.1% year-on-year in April. French industrial output contracted by 0.9% month-on-month in March, while non-farm payrolls increased to 0.3% quarter-on-quarter in Q1. EUR/USD fell by 0.4% this week. While signs are still pointing to a tentative recovery in the euro area, global trade war rhetoric and volatile incoming data continue to weigh on investor sentiment. Trump is poised to delay a decision to impose auto tariffs on EU and Japanese exports by up to six months, which suggests he might ramp up the trade war with China. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Leading economic index and coincident index fell to 96.3 and 99.6 respectively in March. Trade balance by the balance-of-payment measure increased to 700 billion yen in March. Adjusted current account balance fell to 1.27 trillion yen in March. On the housing market front, the construction orders increased by 66.1% year-on-year in March. Housing starts grew by 10% year-on-year in March. Reconstruction efforts following last year’s disasters appear well underway. Machine tool orders contracted by 33.4% year-on-year in April. Japanese producer price inflation decreased to 1.2% year-on-year in April, while still higher than expected. USD/JPY fell by 0.7% initially, then gradually recovered, returning flat this week. The ongoing trade disputes largely increased short-term volatility in the yen. We continue to recommend the yen as a portfolio hedge. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been solid, despite softer employment data: Nominal GDP growth increased to 1.8% year-on-year in Q1. Manufacturing production increased by 2.6% year-on-year in March. Industrial production increased by 1.3% year-on-year. Total trade balance came in at a deficit of 5.4 billion pounds in March. This was an improvement from the last reading of a 6.2 billion deficit in February. ILO unemployment rate fell to 3.8% in March, while the average earnings growth fell from 3.5% to 3.2%. Moreover, claimant count increased by 24.7K in April. GBP/USD fell by 1.6% this week. The pound remains one of our favorite currencies for the time being from a valuation perspective. Moreover, U.K. data continue to surprise positively. The catalyst for pound weakness this week was Theresa May’s announcement she will set out a timetable for her resignation next month, once the fourth iteration of Brexit is submitted for a vote. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been negative: Home loans contracted by 2.5% in March. Crucially, this was driven by both owner-occupied and investor lending. National Australia Bank’s business conditions and business confidence indices both fell in April. Business conditions fell to 3, and business confidence decreased to 0. Westpac consumer confidence fell to 0.6% in May. Consumer inflation expectations fell to 3.3% in May. On the labor market front, the wage price index was unchanged at 2.3% year-on-year in Q1. Unemployment rate increased to 5.2%, while participation rate increased to 65.8%. 28.4 thousand new jobs were created in April. However, this is due to the creation of 34.7 thousand part-time jobs, while 6.3 thousand full-time jobs were lost. AUD/USD fell by 1% this week. We remain overweight the Australian dollar as it will be one of the first pro-cyclical currencies to benefit from Chinese stimulus. But we will respect our AUD/USD 0.68 stop loss if it is breached. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Food price index fell by 0.1% month-on-month in April. Visitor arrivals contracted by 2.6% year-on-year in March. REINZ house sales continue to contract by 11.5% year-on-year in April. Net migration fell to 59 thousand in Q1. Migration has been an important source of demand for New Zealand. NZD/USD fell by 0.4% this week. The New Zealand dollar remains very vulnerable to external shocks, especially from the trade front. Meanwhile, terms of trade dynamics continue to favor AUD vis-à-vis NZD. The domestic environment, including reduced immigration also remains a headwind for the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been promising: Building permits increased by 2.1% month-on-month in March.  On the labor market front, the unemployment rate fell to 5.7% in April, and 106.5 thousand new jobs were created. Participation rate increased to 65.9%, and average hourly earnings increased by 2.6% year-on-year in April. This was a blockbuster jobs report. Headline inflation increased to 2% year-on-year in April, while core inflation decreased to 1.5%. Manufacturing sales increased by 2.1% month-on-month in March. USD/CAD decreased by 0.1% this week. The good news from the Canadian housing sector and labor market has supported the loonie. On Wednesday, Canadian Foreign Affairs Minister Chrystia Freeland called again for the U.S. to lift steel and aluminum tariffs in order to create “true free trade” on the continent. On the U.S. side, Treasury Secretary Steven Mnuchin said that Washington was close to resolving its differences with Mexico and Canada over steel and aluminum tariffs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There is little data from Switzerland this week: Producer and import prices fell by 0.6% in April. USD/CHF fell by 0.1% this week. The Swiss franc remains a safe-haven currency, and growing political uncertainty will increase demand for the franc. We discuss the outlook for the franc at length in the front section of this report. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Core inflation fell to 2.6% year-on-year in April, while still higher than the expected 2.5%.  Headline inflation was unchanged at 2.9% year-on-year in April. Real GDP growth did slow down to a 0.3% quarter-on-quarter pace in Q1. However, seasonal factors were at play. Strong agricultural output in Q4 2018 was not repeated in Q1 following last year’s summer drought. There was also low power production in the months of February and March. The trade balance increased to 17.6 billion NOK in April. USD/NOK has been volatile but returned flat this week. Two Saudi oil-pumping stations were targeted in a drone attack this Tuesday. The tensions in the Middle East increased the risk of oil supply shortages, which is bullish for oil price, thus beneficial for the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Swedish Public Employment Service (PES) unemployment rate fell to 3.5% in April. Headline consumer price inflation climbed to 2.1% year-on-year in April. Core consumer price inflation increased to 1.6% year-on-year in April. USD/SEK has been flat this week. As a pro-cyclical currency, the Swedish krona will soon benefit from a global growth recovery once political uncertainties and external shocks play out. We remain positive on the krona. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature In what has become a tradition, I met with Ms. Mea following client meetings in Europe last week. Ms. Mea is a long-term BCA client who has been following our Emerging Markets Strategy very closely over the years. It was our fourth meet-up in the past 18 months. Ms. Mea keeps our meetings interesting by always challenging our views and questioning the nuances of our analysis. The timing of our most recent meeting was particularly notable, as we had just received news that the latest U.S.-China trade talks had not produced an agreement. In light of this, Ms. Mea started our conversation with a question on the link between geopolitics and financial markets: Ms. Mea: Why have the U.S. and China failed to reach a trade accord when it is clear that without one, both global financial markets and business sentiment will be hurt? Answer: The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Their strategic national interests are not aligned at all. Therefore, any accord on trade and other geopolitical disputes will not be lasting. It is impossible to accurately forecast and time all turns of the negotiation process and the associated event risks. Therefore, an investment process should be informed and guided by a thematic approach. The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Our theme has been, and remains, that China and the U.S. are in a long-term geopolitical confrontation that epitomizes a rivalry between an existing and a rising superpower. This suggests that the demands of one side will be unacceptable to the other. That makes any agreement unsustainable over the long run. In brief, there was a structural regime shift in the U.S.-China relationship last year. Yet global equity markets rallied this year on rising expectations of a major trade deal. Notably, most of the gains in EM equities since late December occurred on days when there was positive news on the progress of trade talks. Hence, the EM rally can largely be attributed to expectations of a trade deal. Not surprisingly, the failure to conclude a trade accord has quickly pushed EM share prices back down to their mid-January levels (Chart I-1). As such, the majority of investors who have bought the EM equity index since early this year lost a substantial part of their gains in the recent selloff.  Chart I-1EM Equity Index: Between Support And Resistance Given that these two nations are embroiled in a long-term geopolitical rivalry, it will be difficult to find solutions on trade and geopolitical disputes that can simultaneously satisfy both sides. Even so, this does not imply that global risk assets will be in freefall forever. Financial markets currently need to price in both (1) a geopolitical risk premium on a structural basis; and (2) the impact of trade tariffs on global business activity on a cyclical basis. Once these two components have been priced in, markets will become less sensitive to the ebbs and flows of tensions between the U.S. and China. Finally, China’s exports to the U.S. constitute only 3.5% of mainland GDP (Chart I-2). This is considerably smaller than capital spending, which makes up 42% of China’s GDP. Further, most of the investment outlays over the past 10 years have not been in productive capacity to supply goods to the American market. On the contrary, the overwhelming share of capital expenditures since 2008 have occurred in domestic segments of the economy rather than export industries. Certainly, the trade confrontation will weigh on consumer and business sentiment in China as well as reduce the flow of U.S. dollars to the Middle Kingdom, warranting RMB depreciation. Still, there are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. China’s exports to the U.S. constitute only 3.5% of mainland GDP. Ms. Mea: With no trade deal, the odds appear to be rising that the Chinese authorities will ramp up both credit and fiscal stimulus. Should investors not be looking through the near-term volatility and be buying EM risk assets and China-plays – because this stimulus will produce a cyclical recovery in the mainland economy? Answer: It is a safe bet that the Chinese authorities will encourage more credit creation and ramp up fiscal spending. The difficulty for investors is in gauging two unknowns: What is the lead time between the stimulus and economic growth, and what will be the multiplier effect of these stimuli. Lead time: Chart I-3 portends our aggregate credit and fiscal spending impulse. Based on the past relationship between turning points in this indicator and the business cycle in China, the latter is likely to bottom around August. Chart I-2Structure Of Chinese Economy Chart I-3China: Stimulus Works With A Time Lag   Chart I-4China's Stimulus And Financial Markets: 2012 Versus 2016 Multiplier effect: The impact of stimulus on the economy also depends on the multiplier effect. The latter is contingent on households’ and companies’ willingness to spend. If households and companies hasten the pace of spending, the economy can recover with little stimulus. If they reduce their expenditure growth, the economy may require much more stimulus. The majority of investors and commentators are comparing China’s current stimulus efforts with what occurred in 2016. However, our hunch is that the current Chinese business cycle might actually resemble the 2012-‘13 episode due to similarities in the multiplier effect. The size of credit and fiscal stimulus in 2012 was as large as in 2016. Nevertheless, the business cycle recovery in 2012-‘13 was very muted, as illustrated in Chart I-3 on page 3. Consistently, EM share prices and commodities did not stage a cyclical rally in 2012 as they did in 2016-‘17 (Chart I-4). Ms. Mea: It seems you are implying that differences between the 2012 and 2016 economic and financial markets outcomes are due to the multiplier. How does one appraise the multiplier effect? Answer: In a word, yes. Unfortunately, there is no easy way to forecast consumers’ and businesses’ willingness to spend – particularly in the midst of a clash between the positive effects of stimulus and the negative sentiment stemming from the ongoing U.S.-China confrontation. We have constructed indicators that measure the willingness to spend among households and companies in China. Our proxies for their marginal propensity to spend (MPS) are currently in decline (Chart I-5A and I-5B). Chart I-5AChina: Households' Marginal Propensity To Spend Chart I-5BChina: Enterprises’ Marginal Propensity To Spend   MPS does not affect day-to-day expenditures, but rather captures consumer spending on large-ticket items such as housing, cars and durable goods, as well as investment expenditures by companies. Consistently, mainland companies’ MPS leads industrial metal prices by several months (Chart I-5B). Chart I-6 illustrates the critical difference between 2012 and 2016 in terms of the impact of credit and fiscal stimulus. In both episodes, the size of the stimulus was roughly the same, but the manufacturing PMI did not really recover in 2012-’13, gyrating in the 49-51 range. In contrast, it did stage a cyclical recovery in 2016-‘17 (Chart I-6, second panel). In brief, the difference between the 2012 and 2016 episodes was the MPS by companies and households (Chart I-6, third and fourth panels). There are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. Provided the not-so-upbeat sentiment among Chinese households and businesses due to their high debt levels and the ongoing trade conflict, the odds are that their MPS will remain weak for now. As a result, the impact of credit and fiscal stimulus on China’s business cycle will be muted for now. As such, more stimulus and longer lead time may be required to engineer a cyclical recovery. Interestingly, the current profiles of both EM and developed equity markets closely resemble their 2012 trajectories – both in terms of direction and magnitude (Chart I-7). Chart I-6China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect Chart I-7Is 2018-2019 Akin ##br##2011-2012? Ms. Mea: So, you are suggesting risks to China-related plays and EM financial markets are skewed to the downside. How should one assess how much downside there is, and what should investors look for to gauge turnings points in financial markets? Answer: We continuously assess the investment landscape, not only based on our fundamental analysis of the global/EM/China business cycles but also on various financial market valuations, positioning and technicals. Let’s review where we stand with respect to these metrics.   Equity Valuations: EM stocks are not cheap. Our favored measure of equity valuations is the composite indicator-based 20% trimmed means of the following multiples: trailing and forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend ratios (Chart I-8). On these metrics, EM stocks appear fairly valued. Nevertheless, these valuations should be viewed in the context of structural decline in EM corporate profitability. The measures of return on equity and assets for non-financial companies in EM are on par with their 2008 lows (Chart I-8, middle and bottom panels). When valuations are neutral, the equity market’s direction is dictated by the profit outlook. The latter currently remains negative for EM and Chinese companies (Chart I-9). Chart I-8EM Equities Are Not Cheap Chart I-9Downside Profit Surprises In EM And China   Currency Valuations: The U.S. dollar is only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs (Chart I-10). The latter is our most favored currency valuation measure. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We reckon that the cyclical and structural backdrop remains favorable for the dollar, and odds are it will overshoot before a major top sets in. Going forward, most of the dollar’s additional gains will not occur versus the euro or the Japanese yen – which are already modestly undervalued (Chart I-10, middle and bottom panels) – but against other currencies. In particular, commodity currencies of developed economies have not yet cheapened enough (Chart I-11). Typically, a structural bear market in commodities does not end until these commodity currencies become cheap. Hence, the current valuation profile of these commodity currencies is consistent with the notion that the secular bear markets in commodities prices and EM are not yet over. Chart I-10The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations Chart I-11Commodities Currencies ##br##Are Not Cheap Yet   Unfortunately, there are no data for unit labor cost-based real effective exchange rates for the majority of EMs. However, it is a safe bet to infer that long- and medium-term cycles in EM currencies coincide with those of DM commodity currencies because they are all pro-cyclical. If DM commodity currencies have not yet bottomed, EM currencies remain vulnerable. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows. Ms. Mea: But the positioning in the U.S. dollar is long. How consistent is this with your view of further dollar strength? Positioning: While investors are long the U.S. dollar versus several DM currencies, they are short the greenback versus EM currencies. Chart I-12 illustrates the aggregate net long positions of both leveraged funds and asset managers in the BRL, MXN, RUB and ZAR. As of May 10 (the last datapoint available), investors were as long these EM high-beta currencies as they were at their cyclical peak in early 2018. As to emerging Asian currencies, ongoing RMB depreciation will drag emerging Asian currencies down. Notably, the Korean won has already broken down from its tapering wedge pattern. Concerning EM equities, investor positioning and sentiment was still very elevated before last week’s market turmoil. Chart I-13 demonstrates the number of net long positions in EM ETFs (EEM) by leveraged funds and asset managers. The last datapoint is also as of May 10. Chart I-12Investors Have Been Long EM Currencies Chart I-13Investors Have Been Bullish On EM Stocks   In short, investor sentiment on EM was bullish and long positions in EM were extended before the U.S.-China trade confrontation escalated again. Tell-tale signs and technicals: Market profiles can sometimes help us gauge whether an asset class is in a bull or bear market, and what the next move is likely to be. We have the following observations: U.S. dollar volatility is close to its record lows (Chart I-14). Following the previous three low-volatility episodes, EM shares prices in dollar terms dropped substantially over the ensuing 18 months – 60% in 1997-1998, 65% in 2007-2008 and 30% in 2014-2015. The rationale is that very low global currency volatility indicates that investors do not foresee a major tectonic macro shift. When this does inevitably occur, currency markets move violently. The RMB depreciation could be a tectonic macro shift that global markets are not prepared for. The absolute and relative performances of EM stocks resemble that of global materials stocks. Global materials are breaking below their long-term moving averages (technical support lines) in absolute terms, raising the odds that the EM equity index will do the same. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows (Chart I-15). Chart I-14U.S. Dollar Volatility And ##br##EM Equity Returns Chart I-15EM And Global Materials: Relative To Global Index Consistently, industrial metals prices as well as our Risk-on/Safe-Haven Currency Index have potentially formed a head-and-shoulders pattern and may be entering a major down leg (Chart I-16). Further weakness in these variables would be consistent with a risk-off phase in EM financial markets.   Finally, the relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – has relapsed relative to the global equity benchmark, failing to break above its long-term moving average (Chart I-17). This is a negative tell-tale sign, and often warrants considerable downside. Chart I-16A Head-And-Shoulder Pattern In Global Cyclical Markets? Chart I-17China All-Share Index: Absolute And Relative Performance   Ms. Mea: It seems to me that the RMB holds the key. What are your thoughts on the Chinese currency? Answer: There are several reasons why the RMB will likely depreciate. First, yuan depreciation is needed to mitigate the impact of U.S. import tariffs on Chinese exporters’ profitability. Authorities could use the RMB depreciation to fight back against U.S. import tariffs – a response that U.S. President Donald Trump will certainly not like. Second, the ongoing cyclical downturn in China and rising deflationary pressures also warrant a cheaper currency. Third, there is a vast overhang of money supply in China: The broad money supply is equivalent to US$30 trillion. More stimulus will only make this oversupply of yuans larger. This, along with the desire of mainland households and businesses to diversify their deposits into foreign currencies/assets, is like “the sword of Damocles” on the yuan’s exchange rate. Finally, the sources of foreign currency that previously offset capital outflows in China are no longer available. The current account surplus has largely evaporated. In addition, the central bank seems to be reluctant to reduce its foreign exchange reserves to fund capital outflows. In fact, at US$3 trillion, its foreign currency reserves are equivalent to only 10% of local currency broad money supply. All in all, we are structurally short the RMB versus the dollar. Chart I-18China, Commodities, & EM: Identical Cycles Ms. Mea: What are the investment implications? Where are we in the EM/China investment cycle? Answer: Our investment themes since early this decade have been that EM share prices and currencies are in a bear market, the U.S. dollar is in a structural bull market, and commodities are in a structural downtrend (Chart I-18). With the exception of 2016-‘17, these themes have played out quite well. These structural moves have not yet been exhausted. At the moment, we do not foresee a 2016-’17-type cyclical rally either. The failure of EM equities to outperform DM stocks and the resilience of the U.S. dollar during the risk-on period since early this year, give us comfort in maintaining a negative stance on EM risk assets. Importantly, a decade-long poor EM performance is likely to end with a bang rather than a whimper, especially when investors by and large remain bullish on EM. On the whole, we recommend trading EM stocks on the short side and underweighting EM equities in a global equity portfolio. Within the EM equity universe, our overweights are Russia, central Europe, Thailand, non-tech Korean stocks, Mexico, Chile, the UAE and Vietnam. Our underweights are Brazil, South Africa, Turkey, Peru, Indonesia, India, and the Philippines. Fixed-income investors should also position for higher volatility and weaker EM currencies, favoring low-beta versus high-beta markets. Russian and Mexican markets are our favored local currency and U.S. dollar bonds. Finally, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Our currency overweights are MXN, RUB, SGD and the THB as well as central European currencies. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

While we remain bullish on global equities and other risk assets over 12 months, we went tactically short the S&P 500 last Friday following the market’s complacent reaction to the Trump Administration’s further tariffs increases on Chinese imports. While a moderate trade war would still produce more economic damage than standard economic models imply, this would be greatly mitigated by significant Chinese economic stimulus and a Fed that is in no hurry to raise rates and could even cut rates. Barring any further major developments, we recommend investors start increasing risk exposure if the S&P 500 falls to 2711. A dip in global bourses would also create an opportunity to go overweight EM/European equities. Favor gold over government bonds as a low-cost hedge against trade war risks for now.

Highlights The clear and present deterioration in Sino-U.S. trade negotiations suggests the dollar will remain bid in the near term. While the probability of a trade deal has fallen, the situation remains highly fluid, and the odds could shift either way rather dramatically. Ultimately, it is beneficial for both parties to come to an agreement. We highlighted last week that in an environment where volatility was low and falling, it paid to have insurance in place. The yen and Swiss franc remain attractive from this standpoint. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Our estimation is that the trade-weighted dollar could rise 2-3% before ultimately cresting. Expect more pronounced USD moves vis-à-vis growth-sensitive currencies. We were stopped out of our short USD/SEK position with a 1.9% loss. If global growth rebounds, this will be a high-conviction trade, but we are standing aside for risk-management purposes. Feature Markets received a dose of volatility this week. First, evidence has emerged that China is retracting on previous commitments toward a Sino-U.S. trade deal. A systematic volte face to core pledges such as legally addressing the theft of U.S. intellectual property and trade secrets, fair competition policy, and removing foreign caps on financial services, aggravated the Trump administration and prompted a new round of tariffs. As we go to press, the final details have not been revealed, but the proposal is to raise tariffs on $200 billion worth of Chinese goods from 10% to 25%, while slapping an additional 25% tariff on the remaining $325 billion of Chinese goods “shortly” after (Chart I-1). Almost simultaneously, tensions between the U.S. and Iran are flaring up following President Trump’s decision not to extend sanction waivers to Iranian oil exports beyond May. The Iranian response has been to threaten to claw back some of the commitments it made in the landmark 2015 nuclear deal, mainly a halt to its uranium enrichment program. The risk of miscalculation and escalation is high. With an aircraft carrier strike group departing from U.S. shores, Tehran could be forced into a corner and begin striking key pipelines in the Iraqi region of Basra, which is home to significant oil traffic. Meanwhile, investor exuberance towards green shoots in the global economy continues to be watered down with incoming data. Chinese export data has weakened anew, both in April and on a rolling three-month basis, following weak PMI numbers last week. Money and credit numbers were soft. Swedish manufacturing data, a strong proxy for global growth, continue to disappoint, with industrial new orders contracting by 8.1% in March – the worst pace since November 2016. And after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks and even A-shares are rolling over (Chart I-2). Chart I-1Back To The Firing Lines Chart 1-2Reflation Indicators Are Topping Out These developments have unsurprisingly put a bid under the dollar against pro-cyclical currencies. However, the euro is up versus the dollar this week, while the DXY marginally down. The lack of more pronounced volatility in currency markets despite a ramp-up in trade-war rhetoric is eery. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Tariffs And Exchange Rates Standard theory suggests that exchange rates should move to equalize prices across any two countries. This is simply because if prices rise significantly higher in country B versus Country A, it pays to buy the goods from A and resell them to B for a profit, assuming other costs are minimal. Country A’s currency rises following increased demand, while that of Country B falls, until the price differential is arbitraged away. This very simple concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). The question that naturally follows is by how much should the currency increase? The answer is that the exchange rate will move by exactly the same percentage point as the price increase, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. But assuming they produce heterogeneous goods, then the loss of purchasing power in Country A will lead to less demand for Country B’s goods. This means Country B’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, since there are no other outlets to liquidate Country A’s goods. If, say, Country A moves to hike prices as well, then both currencies remain at par. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less, in percentage point terms to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs and many other factors that influence tradeable prices, the currency adjustment should be a fraction of the price increase. Since the onset of 2018, the U.S. has slapped various tariffs on China, the most important of which was 10% on $200 billion worth of Chinese goods. Assume for the sake of argument that only China and the U.S. were trading partners. The U.S. currently imports $522 billion worth of goods from China, about 17% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.5% (Chart I-3). This suggests that at best, a 25% increase on all Chinese imports will only lift import prices by 4.3% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 20% of total exports, so a tariff of 25% should only lift export prices by 5%. The conclusion is that the yuan and dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Chart 1-3Sino-U.S. Trade Is Small Relative To Domestic Demand Chart 1-4No Disorderly Rise In ##br##The Dollar   The DXY index is up 10% since the 2018 trough (Chart I-4), and the dollar was up an average of 74 basis points versus the Chinese Yuan from the day major tariffs were announced until the peak in trade-war rhetoric (Table I-1). This would be in line with economic theory. But there is a caveat: With no corresponding export subsidy for U.S. goods, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this would have a meaningful dent on corporate profits. A paper by the Peterson Institute for International Economics showed that imposing a border adjustment tax caused the real effective exchange rate (REER) of the country to rise, hurting competitiveness.1  In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.2  With the dollar not currently overvalued on a REER basis, this does not bode well for future competitiveness (Chart I-5). Finally, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides toward an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the Midwestern battleground states is a thorn in his side. The U.S. agricultural sector has continued to bleed from falling grain prices (Chart I-6). For President Xi, rising unemployment is a key constraint. April manufacturing and credit numbers out of China show that the economy is relapsing anew. So, either China compromises and inches towards a trade deal or launches another round of stimulus. Chart I-5The Dollar Is Not Undervalued On A REER Basis Chart I-6A Drought In Cash Flows For ##br##U.S. Farmers   Bottom Line: Standard theory suggests the dollar’s bid should be capped at 2-3% on the imposition of new tariffs. Getting the global growth picture right will be more important in dictating the dollar’s trend. Of course, a full-blown trade war puts the entire thesis in jeopardy. Questions From The Road We were on the road this week, talking to clients and teaching the BCA Academy. Most clients agreed that the dollar is in a transition phase, given the presence of emerging green shoots in the global economy (Chart I-7). However, most were also concerned to what degree this view could be offside. The concerns centered around the fact that the growth differential between the U.S. and the rest of the world remains wide, yield differentials still favor the U.S., profit leadership also continues to favor the U.S. and it is unclear to what degree the world is short of U.S. dollars. U.S. profit leadership in the world continues, but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones.  We continue to lean towards the narrative that most of the factors driving the dollar higher are behind us. U.S. growth tends to be low-beta relative to the world, so a rebound in the global economy will be negative for the dollar. An end to the Federal Reserve’s balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. Meanwhile, a rising external profit environment will lead to an increase in foreign central bank reserves. The yield differential between the U.S. and the rest of the world remains wide, but this has a natural limit since global bond yields tend to converge towards each other over time. Chart I-7Global Growth Should##br## Rebound Chart I-8Positive Earnings Revisions Bodes Well For Growth   U.S. profit leadership in the world continues (Chart I-8), but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones. A better external environment will suggest banks will allow credit to flow to larger firms relative to smaller ones, since the latter tend to be more domestic. This is also an environment where global equities tend to outperform. The latest Fed Senior Official Loan survey showed that on the margin, lending standards are easing for large relative to small firms. This may suggest that return on capital is starting to improve outside the U.S., which will be a headwind for the dollar (Chart I-9). Chart I-9S&P 500 Foreign Earnings Need A Weak Dollar From a technical standpoint, almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now. This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. dollar long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked (Chart I-10). It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions.  Dollar technicals are also very unfavorable. Speculators are holding near-record long positions, sentiment is stretched, and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion (Chart I-11). This may help explain relative stability in the broad trade-weighted dollar, despite a flare up in global risk aversion. Chart I-10Dollar Bull Case Is Well Known Chart I-11Dollar Technicals Are Unfavorable   Finally, with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. The strength in EUR/USD this week despite the rise in global risk aversion is testament to this thesis. Bottom Line: Aside from the renewed specter of a trade war, most of the factors driving the dollar higher are behind us. House Keeping Chart I-12Buy Some Insurance Rising market volatility suggests some trades could be at risk from being stopped out. First, our long AUD/USD sits right at the epicenter of any growth slowdown in China. Maintain stops of 68 cents. Second, in an environment where volatility is low and falling, it pays to have insurance in place. We continue to favour CHF/NZD (Chart I-12). Third, we were stopped out of our short USD/SEK position for a 1.9% loss. If global growth rebounds, this will be a high-conviction trade. However, we are standing aside for risk-management purposes. Finally, the Reserve Bank Of Australia kept rates on hold this week, while the Reserve Bank Of New Zealand cut rates. This bodes well for our strategic AUD/NZD position.     Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Caroline Freund and Joseph E. Gagnon, “Effects of Consumption Taxes on Real Exchange Rates and Trade Balances,” Peterson Institute for International Economics, April 2017. 2 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: To begin with the labor market, the unemployment rate fell to a 50-year low of 3.6% in April, despite a slight fall in the participation rate to 62.8%. Change in nonfarm payrolls came in above expectations at 263K in April, while average hourly earnings was unchanged at 3.2%. Moreover, JOLTS job openings came in at 7.5 million, above expectations. On the PMI front, the Markit composite PMI fell to 53 in April. ISM non-manufacturing PMI fell below expectations to 55.5. On the housing market front, mortgage applications increased by 2.7%, an improvement from the last reading of -4.3%. This nudged the MBA Purchase Index from 259.4 to 270.2. DXY index fell by 0.2% this week. On Sunday, Trump tweeted that tariffs on $200 billion worth of Chinese imports will increase from 10% to 25%, which again toppled the market. The ongoing trade disputes increase uncertainty in the global growth outlook. Report Links: Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area are improving: Headline and core inflation in the euro area rose to 1.7% and 1.2% year-on-year, respectively in April. Markit composite and services PMI came in at 51.5 and 52.8, respectively, both surprising to the upside. The French composite and services PMI increased to 50.1 and 50.5. The German composite and services PMI increased to 52.2 and 55.7. Sentix investor confidence rose to 5.3 in May, well above consensus. Retail sales increased by 1.9% year-on-year in March. EUR/USD appreciated by 0.3% this week. The European Commission (EU) released the spring 2019 Economic Growth Forecasts this week, citing that “growth continues at a more moderate pace.” While the global growth slowdown and trade policy uncertainties could weigh on the European economy, domestic dynamics are set to support the economy. According to the forecast, growth will continue to pick up in all EU member states next year. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been neutral: Nikkei composite PMI increased to 50.8 in April. The manufacturing PMI increased to 50.2, while the services PMI fell slightly to 51.8. Vehicle sales increased by 2.5% year-on-year in April. Consumer confidence index fell to 40.4 in April. USD/JPY fell by 0.9% this week. Volatility caused by the ongoing trade disputes has reduced risk appetite, enhancing the outperformance of the safe-haven yen. According to the BoJ minutes released this Wednesday, Japanese financial conditions remain highly accommodative, and the domestic demand is likely to bounce, despite the drag from external growth. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been solid: Markit composite PMI increased to 50.9 in April. Services PMI also came in above expectations at 50.4 in April, an improvement from the last reading of 48.9. The British Retail Consortium (BRC) like-for-like retail sales increased by 3.7% year-on-year in April, outperforming expectations. Halifax house prices increased by 1.1% month-on-month in April and 5% year-on-year. GBP/USD fell by 0.9% this week, erasing the gains from last Friday after positive PMI data. We continue to favor the pound given its cheap valuation and healthy domestic fundamentals. However, the window for pound upside will rapidly close as we approach Brexit 2.0. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: CBA Australia composite and services PMI both outperformed, increasing to 50 and 50.1, respectively. Building permits contracted by 27.3% year-on-year in March. However, this looks like a volatile bottoming process on a chart. Retail sales increased by 0.3% month-on-month in March. The trade balance came in at a surplus of A$4.95 million in March. AUD/USD has been flat this week. The Reserve Bank of Australia kept interest rate on hold at 1.5% this week, which disappointed the bears. Moreover, in the monetary policy statement, the RBA estimates the economy will grow around 2.75% in 2019 and 2020, supported by increased investment and a pickup in the resources sector. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ commodity prices increased by 2.5% in April, higher than expected. 2-year inflation expectations remain at 2%. Dairy price index increased by 0.4% in April, above the estimated -1.1%. NZD/USD fell by 0.5% this week. On Tuesday, the RBNZ lowered its interest rate by 25 bps to 1.5%. Our long AUD/NZD position, which is currently 0.8% in the money, is likely to profit from the widened interest rate differential. In the monetary policy statement, the RBNZ stated that a lower rate is mostly consistent with the current employment and inflation outlook in New Zealand. Moreover, global uncertainties, coupled with domestic housing market softness and reduced immigration remain a headwind to the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: Ivey Purchasing Managers’ Index increased to 55.9 in April, well above estimates. Housing starts increased by 236K year-on-year in April. Imports and exports increased to C$52 billion and C$49 billion respectively in March, resulting in a small deficit of C$3 billion. New housing price index increased by 0.1% year-on-year in March. USD/CAD has been flat this week. On Monday, Governor Poloz gave a speech focusing on the Canadian housing sector. He aims to provide more flexible mortgage choices for Canadian consumers, which could help the housing market to stabilize. The possible measures include diversifying mortgage terms, developing an MBS market, and encouraging different mortgage designs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been neutral: Headline inflation fell to 0.2% in April on a month-on-month basis, while unchanged at 0.7% on a year-on-year basis. Core inflation was unchanged at 0.5% year-on-year. Foreign currency reserves increased to 772 billion CHF in April. Unemployment rate was unchanged at 2.4% month-on-month in April. The SECO consumer climate fell to -6 in Q2. USD/CHF fell by 0.2% this week. While the trade disputes and increased global growth uncertainties could support the Swiss franc in the near term, we continue to favor the euro over the franc on a cyclical basis. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Registered unemployment fell to 2.3% in April. Manufacturing output contracted by 0.8% in March. House prices rose by 2.2% year-on-year in April, below March’s 3.2% annual growth. USD/NOK increased by 0.2% this week. On Thursday, the Norges Bank kept interest rates on hold at 1%, in line with expectations. The monetary policy continues to be accommodative, which is a tailwind for the Norwegian economy. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industrial production contracted by 1.3% year-on-year in March. Manufacturing new orders decreased by 8.1% year-on-year in March, the worst since November 2016. USD/SEK increased by 0.8% this week. Our short USD/SEK position was stopped out at 9.6, due to the weaker-than- expected Swedish data and unexpected U.S. dollar resilience. We will look to put the trade back on when we see more clear signs of a global growth bottom. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese housing market with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Ellen’s previous housing report was extremely well received,1 and clients should look forward to tomorrow’s update. Chart 1A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook Turning to the financial markets, investors have been squarely focused this week on the sudden escalation in tension between the U.S. and China, caused by President Trump’s renewed threat on May 5 to heighten tariffs on Chinese imports at the end of this week. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. The financial market reaction was swift: Chinese A shares fell nearly 6% on Monday, and USD-CNY surged nearly half a percent (Chart 1). Chinese stocks fared better on Tuesday, but may come under pressure again later in the week as China’s trade delegation returns to the U.S. for talks on Thursday & Friday. Despite this week’s volatility, we would not yet recommend any portfolio strategy changes to investors who are positioned in favor of Chinese stocks or China-related assets more generally. First, we still see the combined odds of a deal or a further extension in talks as being as high as 60%, and investors would view an agreement to extend the negotiations in a positive light after this week’s selloff. At a minimum, investors are likely to get a better chance to sell in such a scenario. Second, over that past year we have steadfastly maintained that China’s economy and its earnings cycle are driven by monetary conditions, money, and credit growth, and two of these three drivers are clearly now pointing to improving economic activity over the coming year. Certainly, the imposition of a 25% import tariff on all Chinese goods would represent a new, negative shock to the Chinese economy, but in this scenario Chinese policymakers would also substantially dial up their reflationary response. As such, while the near-term response in the equity market is likely to be very negative if President Trump follows through with his threat, the cyclical (i.e. 6-12 month outlook) for Chinese relative equity performance is not yet clear. This is only true in local currency (i.e. hedged) terms, however, as we agree that there is meaningful downside potential for the RMB in a full tariff scenario. So while we are likely to advise investors to wait and assess the likely reflationary response if a 25% “second round” tariff rate is imposed this week before changing their equity stance, we would recommend a long USD-CNY/CNH position in the interim as a hedge against a potentially substantial decline in the RMB. Stay tuned.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1      Please see BCA Research’s China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?,” published September 13, 2018. Available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights Recent data suggest central bankers remain behind the curve in boosting inflation expectations. Ergo, expect a dovish bias to persist over the next few months. Our thesis remains that global growth is in a volatile bottoming process. However, market focus could temporarily flip towards short term data weakness, which warrants taking out some insurance. Meanwhile, in an environment where volatility is low and falling, it also pays to have insurance in place. Rising net short positioning in the yen and Swiss franc is making them attractive from a contrarian standpoint. Maintain a limit-buy on CHF/NZD at 1.45. The path of least resistance for the dollar remains down. This is confirmed by incoming data that suggests the euro area economies have bottomed, which should boost the EUR/USD. The rising dollar shortage remains a key risk to our sanguine view. But the forces driving dollar liquidity lower are largely behind us. Feature Investors looking for more clarity on the global growth picture from the April data print have been left in a quandary. In the U.S., the headline first-quarter real GDP growth number of 3.2% was well above consensus but was boosted by volatile components such as inventories and net exports. Real final sales to domestic purchasers, a cleaner print for final demand, came in at 1.5%, the lowest increase since 2015. Assuming trend growth in the U.S. is around 2%, a view shared by the Federal Open Market Committee (FOMC), then the increase in first-quarter final sales was a big miss. Most importantly, the U.S. ISM manufacturing index fell to 52.8 in April, a drop that was broad-based across seven of the 10 components. Chart I-1At The Cusp Of A V-Shaped Recovery? Across the ocean, European growth was a tad stronger. Italy managed to nudge itself out of a technical recession, while Spanish year-on-year growth of 2.4% helped drive euro area GDP growth to the tune of 1.2%. The most volatile components of euro area growth tend to be investment and net exports. Should both pick up on the back of stronger external demand, then GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently one of the weakest in the euro zone. But forward-looking indicators suggest we are at the cusp of a V-shaped bottom over the next month or so (Chart I-1). China remains the epicenter of any growth pickup and the headline PMI numbers were soft, with the official NBS manufacturing PMI falling to 50.1 from 50.5, and the private sector Caixin manufacturing PMI falling to 50.2 from 50.8. Still, the numbers remain above the critical 50 threshold level, and well beyond the 45-48 danger zone. Export growth numbers across southeast Asia remain weak, and after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks, and Asian currencies are all rolling over. The bearish view is that there are diminishing marginal returns to Chinese stimulus, and the authorities need to be more aggressive to turn the domestic economy around. The reality is that policy stimulus works with a lag, and we need about three to six months before we see the effects of the current policy shift. Southeast Asian exports track the Chinese credit impulse with a lag of six months, and there is little reason to believe this time should be different (Chart I-2). Chart I-2Global Trade Should Soon Bottom The broad message is that global growth likely bottomed in the first quarter. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data, making for a volatile bottoming process. We recommend maintaining a pro-cyclical bias, but taking out some insurance against a potential spike in volatility.  The Fed On Hold This week’s FOMC meeting focused on the lack of inflationary pressures in the U.S. but was largely a non-event for financial markets, aside from a spike in volatility. Nonetheless, there were three key takeaways. First, the dip in inflation appears to be “transitory,” driven by lower clothing prices and financial services fees. Second, Chair Powell made it clear that the Fed will only feel the need to ease policy if inflation runs “persistently” below target. Finally, the Fed’s interpretation of its “symmetric” inflation target is slowly shifting. Many FOMC members increasingly believe that the Fed should explicitly pursue an overshoot of its 2% inflation target to make up for past misses. Taken together, we expect the Fed to remain on hold for the time being, but to eventually start raising rates again as inflationary pressures pick up. Chart I-3Inflation Should Be Higher In The U.S. Versus The Euro Area The bigger picture is that in a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective. This is because, should inflation be on the rise and moving higher in one country, expectations of higher interest rates should lift its currency, which eventually tempers inflationary pressures, and vice versa. This is obviously a very simplistic view of the world economy, since other factors such as demographics, productivity, labor mobility, openness of the economy, and policy divergences among others, play important roles. However, it is remarkable that almost every developed market central bank has continued to attempt to boost inflation to the 2% level since the Global Financial Crisis, but very few have been able to achieve this independently. In a very globalized world with fully flexible exchange rates, it is becoming more and more difficult for any one central bank to independently achieve its inflation objective.  Take the case of Europe versus the U.S., two economies that could not be more different. Euro area imports constitute about 41% of GDP, while the number in the U.S. is only 15%, so tradeable prices matter a lot more for the former. Meanwhile, the demographic profile is worse in Europe, with the old-age dependency ratio at 32% in Europe versus 23% in the U.S. Finally, other measures of supply-side constraints such as labor market slack or capacity utilization suggest the euro area is well behind the U.S. on the path toward a closed output gap (Chart I-3). Despite this, since 2015, headline inflation in both the U.S. and euro area have moved tick-for-tick. Yes, policy divergences between the two countries have been very wide, either via the lens of quantitative easing or simply the differential in policy rates (Chart I-4). But the fact that the magnitude and direction of overall inflation has moved homogenously, begs the question of the ability of either central bank to influence overall prices. One explanation could be that variations in headline CPI are largely driven by volatile items that tend to be exogenous, while variations in core CPI tend to be mostly driven by endogenous factors. This is confirmed by most research that suggest there is a weak link between rising commodity prices and longer-term inflation.1 That said, over the shorter run, commodity price gyrations can dominate and be the main driver of inflation expectations (Chart I-5). Chart I-4U.S. And Euro Area Overall CPI Are Broadly Similar Chart I-5In The Short Term, Commodity Prices Matter For Inflation Expectations The bottom line is that muted inflationary pressures are a global phenomenon, and not centric to the U.S. This means that as a whole, global central banks are set to stay accommodative for the time being, which will be bullish for global growth (Chart I-6). This warrants maintaining a pro-cyclical stance but being extremely selective in what might be a volatile bottoming process. Chart I-6Global Monetary Policy Needs To Ease Further Maintain A Pro-Cyclical Stance With the S&P 500 breaking to all-time highs, crude oil prices up around 40% from their lows, and U.S. 10-year Treasury yields rolling over relative to the rest of the world, this has historically been fertile ground for high-beta currency trades. That said, the lack of more pronounced strength in pro-cyclical currencies like the Australian, New Zealand, and Canadian dollars suggest that caution prevails. Our bias is that currency markets continue to fight a tug-of-war between strong dollar fundamentals and fading tailwinds. Our portfolio consists mostly of trades along the crosses, but we have been cautiously adding to U.S. dollar short positions over the past few weeks: Long AUD/USD: Our limit-buy on the Aussie was triggered at 0.70. Data out of Australia are showing tentative signs of a bottom. Last week’s important jobs report showed that the economy continues to offer more employment than the consensus expects. Meanwhile, the credit growth data out of Australia this week suggests that macro-prudential policies continue to drive a wedge between owner-occupied and investor housing (Chart I-7). House prices in Australia are already deflating to the tune of around 6%. Once the cleansing process is through, we expect house price growth to eventually converge toward levels of credit and/or natural income growth. Moreover, the Australian dollar remains a commodity currency, and will benefit from rising terms-of-trade. Iron ore prices remain firm on the back of supply-related issues. Meanwhile, a rising mix of liquefied natural gas in the export basket will provide tailwinds as China continues to steer its economy away from coal. Finally, Chinese credit growth has been a key determinant of the re-rating of Australian equities. Ergo, a rising Chinese credit impulse will ignite Australian share prices, and by extension the Australian dollar (Chart I-8). Chart I-7Australian Credit Growth Converging To Steady State Chart I-8More Chinese Credit Will Help Australian Equities Long GBP/USD: Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued back then, the pound is sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit have significantly fallen since then. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape. Full-time employees continue to creep higher as a percentage of overall employment (Chart I-9). This view was echoed in yesterday’s Bank Of England (BoE) policy meeting, where the central bank raised its growth forecast while striking a more hawkish tone. Chart I-9U.K.: What Brexit? Chart I-10Sweden: Volatile Bottom   Long SEK/USD: The Swedish krona should be one of the first currencies to benefit from any bottoming in European growth (Chart I-10). The Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is trading at its lowest level since the global financial crisis (Chart I-11). Economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The main appeal of the Swedish krona is that it is extremely cheap. Meanwhile, despite negative interest rates, Swedish household loan growth has been slowing as consumers are increasingly financing purchases through rising wages. This will alleviate the need for the Riksbank to maintain ultra-accommodative policy, despite its recent dovish shift. Buy Some Insurance Given current low levels of volatility and elevated equity market valuations, the dollar would have been a great insurance policy for any stock market correction. But with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs.  Chart I-11How Much Lower Could The Swedish Krona Go? Chart I-12Buy Some##br## Insurance It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and some carry trades are unwound, unhedged trades will become victim to short-covering flows. Currencies such as the Japanese yen and the Swiss franc that could have been used to fund carry trades are ripe for reversals. This suggests at a minimum building some portfolio hedges. One such hedge is going long the CHF/NZD. This trade has a high negative carry, so we do not intend to hold it for longer than three months. But it should pay off handsomely on any rise in volatility (Chart I-12). Maintain a limit-buy at 1.45.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Stephen G Cecchetti and Richhild Moessner, “Commodity Prices And Inflation Dynamics,” Bank Of International Settlements, Quarterly Review, (December 2008). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. continue to moderate: Annualized Q1 GDP came in at 3.2% quarter-on-quarter, well above estimates. Personal income increased by 0.1% month-on-month in March, below the estimated 0.4%. On the other hand, personal spending increased by 0.9% month-on-month in March. PCE deflator and core PCE deflator fell to 1.5% and 1.6% year-on-year, respectively in March. Michigan consumer sentiment index slightly increased to 97.2 in April. Markit manufacturing PMI increased from 52.4 to 52.6 in April, while ISM manufacturing PMI fell to 52.8. Q1 nonfarm productivity increased by 3.6%, surprising to the upside. DXY index fell by 0.3% this week. On Wednesday, the Fed announced their decision to keep interest rates on hold at current levels, further suggesting that there is no strong case to move rates in either direction based on recent economic developments. Moreover, Fed chair Powell reiterated their strong commitment to the 2% inflation target. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area are improving: Money supply (M3) in the euro area increased by 4.5% year-on-year in March. The sentiment in the euro area remains soft in April: economic sentiment indicator fell to 104; business climate fell to 0.42; industrial confidence fell to -4.1; consumer confidence was unchanged at -7.9. Q1 GDP came in at 1.2% year-on-year, surprising to the upside. Unemployment rate fell to 7.7% in March. Markit PMI increased to 47.9 in April. EUR/USD appreciated by 0.3% this week. European data keep grinding higher. Italian GDP moved back into positive territory in Q1. Spanish GDP also rebounded in Q1. Positive Chinese credit data suggests the euro will soon benefit from rising Chinese imports.  Report Links: Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: The unemployment rate in March increased slightly to 2.5%; job-to-applicant ratio was unchanged at 1.63. Tokyo consumer price inflation increased to 1.4% year-on-year in March, the highest level since October 2018. Industrial production fell by 4.6% year-on-year in March. However, projections for April suggest a 2.7% month-on-month jump. Retail sales grew by 1% year-on-year in March, higher than expected. Housing starts grew by 10% year-on-year in March. This is the highest growth level since February 2017. USD/JPY fell by 0.2% this week. The Japanese government’s intention to raise sales tax this October could be a highly deflationary outcome. However, there is still an outside chance that the tax hike will be postponed. We continue to recommend yen as a safety hedge. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been positive: U.K. mortgage loans in March increased to 40K.  Nationwide housing prices increased by 0.9% on a year-on-year basis in April. Markit manufacturing PMI came in above expectations at 53.1 in April, even though it fell; Markit construction PMI however increased to 50.5. Money supply (M4) increased by 2.2% year-on-year in March. GBP/USD increased by 1% this week. The Bank of England kept rates on hold at 0.75% this week. In the May inflation report, the BoE mentioned that U.K.’s economic outlook will depend significantly on the nature and timing of EU withdrawal, and the new trading agreement with EU in particular. But governor Carney struck a slightly hawkish tone, revising up GDP estimates and guiding the next policy move as a rate hike. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have shown tentative signs of recovery: Private sector credit growth fell to 3.9% year-on-year in March. However, this is heavily biased downwards by lending to home investors that has slowed to a crawl. The Australian Industry Group (AiG) manufacturing index increased to 54.8 in April. RBA commodity index increased by 14.4% year-on-year in April. AUD/USD fell by 0.4% this week. The data are starting to look brighter in Q2, suggesting that the economy might have bottomed in Q1. The Australian dollar is likely to grind higher, especially driven by rising terms of trade. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand are mixed: ANZ activity outlook increased by 7.1% in April. ANZ business confidence in April improved to -37.5. On the labor market front in Q1, the employment change fell to 1.5% year-on-year; unemployment rate was unchanged at 4.2%, but participation rate fell to 70.4%; labor cost index fell to 2% year-on-year. Building permits contracted by 6.9% month-on-month in March. NZD/USD depreciated by 0.4% this week. The data from New Zealand continue to underperform its antipodean neighbor. We anticipate this trend will persist. Stay long AUD/NZD, currently 0.5% in the money. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada continue to underperform: GDP in February contracted by 0.1% on a month-on-month basis. Markit manufacturing PMI fell below 50 to 49.7 in April.  USD/CAD fell by 0.1% this week. During Tuesday’s speech, Governor Poloz acknowledged recent negative developments in the Canadian economy, and blamed it on the U.S.-led trade war, as well as the sharp decline in oil prices late last year. While a bottoming in the global growth could be a tailwind for the Canadian economy near-term, a Ricardian equivalence framework will suggest fiscal austerity over the next few years, will be a headwind for long-term CAD investors. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 96.2 in April. Real retail sales contracted by 0.7% year-on-year in March. SVME PMI fell below 50 to 48.5 in April. USD/CHF fell by 0.1% this week. The reduced volatility worldwide could make the Swiss franc less attractive. Moreover, the relative outperformance of the euro area is a headwind for the franc. Our long EUR/CHF position is now 1% in the money. We intend to trade the franc purely as an insurance policy near-term. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.6% in March, in line with expectations. This was a marked improvement from the 1.2% drop in February. The unemployment rate held low at 3.8% USD/NOK increased by 1% this week. We expect the Norwegian krone to pick up based on the strong fundamentals and positive oil price outlook. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: Retail sales increased on a month-on-month basis by 0.5% in March, but fell to 1.9% on a yearly basis. Producer price index was unchanged at 6.3% year-on-year in March. Trade balance came in at a large surplus of 7 billion SEK in March. Manufacturing PMI fell to 50.9 in April, but notably, import orders and backlog orders rose.  USD/SEK increased by 0.4% this week. Despite the RiksBank’s dovish shift last week, we continue to favor our long SEK position. Our conviction is rooted in the fact that the Swedish krona is undervalued, and relative PMI trends favor Sweden vis-à-vis the U.S. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com