Currencies

Dear client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. Next week, please join me for a webcast on Thursday, July 9 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Markets will trade nervously over the coming weeks in response to the second wave of the pandemic and the looming US fiscal cliff. Nevertheless, we would “buy the dip” if global equities were to fall 5%-to-10% from current levels. While the pace of reopening will slow, there is little appetite for the sort of extreme lockdown measures that were implemented in March. The US Congress will ultimately extend fiscal support for households and firms. Around the world, both fiscal and monetary policy will remain highly accommodative, which should provide a supportive backdrop for stocks. Many institutional investors missed the rebound in stocks and are eager to get back in. High levels of “cash on the sidelines” will further buttress equities. Remain overweight stocks versus bonds on a 12-month horizon. Favor cyclical sectors over defensives and non-US stocks over their US peers. The US dollar has entered a bear market. A weaker greenback will boost commodity prices and EM assets. Global bond yields will rise modestly over the next few years. However, they will remain extremely low by historic standards. Bond yields will only surge once inflation reaches uncomfortably high levels. At that point, the equity bull market will end. Fortunately, this is unlikely to happen for at least three years. I. Macro And Markets Financial markets’ response to the pandemic has followed three distinct phases: Phase One: Hope and Denial. While equities did buckle on the news that a previously unknown coronavirus had emerged in China, they quickly recovered in the hope that the epidemic would be contained. Equities remained resilient even as the virus resurfaced in South Korea and Iran, prompting us to pen a report in February entitled “Markets Too Complacent About The Coronavirus.”1 Phase Two: The Wile E. Coyote Moment.2 The second phase began with the outbreak in Italy. Scenes of overflowing emergency rooms prompted governments to order all non-essential workers to stay home. The resulting decline in commerce caused equities to plummet. Credit spreads widened, while funding markets began to seize up (Chart 1). Phase Three: Recovery. With memories of the 2008 global financial crisis still fresh in their minds, policymakers sprung into action. The combination of massive monetary and fiscal easing helped stabilize financial markets. Risk assets received a further boost as the number of new cases in Italy, Spain, New York City and other hotspots began to decline rapidly in April (Chart 2). The hope that lockdown measures would be relaxed continued to power stocks in May and early June. Chart 1Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Chart 2Sharp Decline Of New COVID-19 Cases In April Allowed Equities To Recover Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Fast forward to the present and things do not seem as straightforward. Despite today’s rally, global equities are still down 4.7% from their June 8th high. The key immediate question for investors is whether the recent bout of volatility marks the end of Phase Three or just a temporary pause in a new cyclical bull market for stocks. On balance, we lean towards the latter scenario. As we discuss in greater detail below, while we do think that the next few months will be more treacherous for investors due to a resurgence in the number of Covid cases in some countries, as well as uncertainty over how the looming US fiscal cliff will be resolved, we expect global equities to be higher 12 months from now. Stocks And The Economy Pundits such as Paul Krugman often like to recite the mantra that “the stock market is not the economy.” While there is some truth to that, equities still tend to track the ups and downs of the business cycle. This can be observed simply by looking at the strong correlation between the US ISM manufacturing index and the S&P 500 (Chart 3).  Chart 3Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks As happened in 2009 and during prior downturns, stocks bottomed this year at roughly the same time as leading economic indicators such as initial unemployment insurance claims peaked (Chart 4). Chart 4Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Will the economic data continue to improve, allowing equities to move higher? In the past, recoveries following exogenous shocks have tended to be more rapid than those following recessions that arose from endogenous problems. The pandemic would seem to qualify as an exogenous shock. Temporarily furloughed workers have accounted for the vast majority of the increase in US unemployment this year (Chart 5). As lockdown measures are relaxed, the hope is that most of these workers will return to their jobs. Chart 5Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Bumps In The Road Nevertheless, the recovery will be a bumpy one. In the near term, the main barrier will be the virus itself. Globally, the number of new cases has been trending higher since early May. The number of deaths has also reaccelerated (Chart 6). In the US, the epicenter of the pandemic has shifted from the Northeastern tri-state corridor to the southern states. Florida, Texas, and Arizona have been particularly hard hit. Contrary to President Trump’s claims, more testing does not explain the rise in case counts. As Chart 7 shows, the fraction of tests coming back positive has actually been trending higher in all three states. Chart 6Globally, The Number Of New Cases Has Been Trending Higher Since Early May, While The Number Of Deaths Has Moved Off Its Recent Lows Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 7Fraction Of Tests Coming Back Positive Has Been Moving Higher In Certain States Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave It did not have to be this way. The evidence suggests that the widespread use of masks could have kept the virus at bay while still allowing most economic activities to resume (Chart 8). Unfortunately, the question of whether to wear a mask, like almost everything else in the US, has become another front in the culture war. Chart 8Masks On! Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Mask wearing is much more common in China and the rest of east Asia, which is one key reason why the region has suffered far fewer casualties than elsewhere. Hence, a second wave is likely to be much more muted there. Western Europe, Australia, and New Zealand should also remain largely unscathed going forward. Luckily, treatment options have improved over the past few months, as medical professionals have learned more about the virus. Hospitals have also built up capacity to deal with an influx of patients. Another less well recognized development is that protocols have been put in place to protect residents in long-term care facilities. In Canada, more than 80% of COVID deaths have occurred in nursing homes. All this suggests that while a second wave will weigh on global growth over the coming months, we are unlikely to see the sort of broad-based economic dislocations experienced in March. A Structural Break Even if a second wave does not turn out to be as disruptive as the first, it probably will be several years before spending in the sectors most affected by the virus returns to pre-pandemic levels. Indeed, there is a chance that some sectors may not ever fully recover. The technology to work from home was in place before the pandemic began. Many workers chose not to do so because they did not want to be the odd ones out. The pandemic may have nudged society to a new equilibrium where catching a red-eye flight to attend a business meeting becomes more the exception than the rule, while working from home is seen as perfectly acceptable (and safer) than going to the office. If that happens, there will be, among other things, less business travel going forward, as well as less demand for office space. Such a transformation could end up boosting productivity down the road by allowing companies to slash overhead costs and unnecessary expenses. However, it will impose considerable near-term dislocations, particularly for airlines, hotels, commercial real estate operators and developers, and associated lenders to these sectors. The Role Of Policy It would be unwise for policymakers to try to prevent the shift of capital and labor towards sectors of the economy where they can be more efficiently deployed. However, policy can and should smooth the transition. Chart 9Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Most of the suffering during recessions comes in the form of collateral damage. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 9). One does not have to fill a half-empty swimming pool through the same pipe from which the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs will likely find new jobs in other sectors. This is where the role of monetary and fiscal policy takes center stage. Central banks moved quickly to ease monetary policy as soon as the pandemic began. Unfortunately, with rates already quite low in most countries, there was only so much that conventional monetary policy could achieve. The Federal Reserve, which had more scope to cut rates than most, brought the fed funds rate down 150 bps to a range of 0%-to-0.25%. As helpful as this action was, it fell well short of the more than five percentage points in easing that the Fed has delivered, on average, during past recessions (Chart 10). Chart 10Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around With conventional monetary policy constrained by the zero lower bound, central banks turned to unconventional tools, the most important of which were asset purchases, lending backstops, and forward guidance. These tools blurred the line between fiscal and monetary policy. To some extent, this was by design. By offering to buy government debt in unlimited quantities and at extremely low rates, central banks incentivized governments to run larger budget deficits. Even if one excludes loan guarantees, governments have eased fiscal policy by an extraordinary degree this year (Chart 11). The G7 as a whole has delivered 11.7% of GDP in fiscal stimulus, compared to 4% of GDP in 2008-10. In China, we expect the credit impulse to reach the highest level since the Global Financial Crisis, and the budget deficit to hit the highest level on record (Chart 12).  Chart 11Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 12China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots   Fiscal Austerity? Don’t Bet On It The recovery following the Great Recession was hampered by the decision of many governments, including the US, Germany, and Japan, to tighten fiscal policy prematurely, despite a lack of pressure from bond markets to do so. While a repeat of such an outcome cannot be excluded, we think it is quite unlikely. Politically, stimulus remains very popular (Table 1). Unlike during the housing bust, there has been little moral handwringing about bailing out households and firms that “don’t deserve it.” Thus, while the US faces a daunting fiscal cliff over the next two months – including 3% of GDP in expiring Paycheck Protection Program funding and over 1% of GDP in expanded unemployment benefits and direct payments to individuals – we expect Congress to ultimately take action to avert most of the cliff. Table 1There Is Much Public Support For Fiscal Stimulus Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave This will probably involve rolling over some existing programs and supplanting others with new measures such as increased aid to state and local governments. The same pattern is likely to be repeated globally. II. Long-Term Focus: Inflation And The Fiscal Hangover The combination of large budget deficits and falling output has caused the ratio of government debt-to-GDP to explode. The IMF now expects net government debt to reach 132% of GDP in advanced economies in 2021, up from an earlier estimate of 104% made last October (Chart 13). What will happen to all that debt? The answer partly hinges on what happens to the neutral rate of interest, or more precisely, the difference between the neutral rate and the trend growth rate of the economy. The neutral rate of interest is the interest rate that is consistent with full employment and stable inflation. When policy rates are above the neutral rate, unemployment will tend to rise, and vice versa. Most estimates of the neutral rate, such as those produced by the widely used Laubach-Williams model, suggest that it is currently quite low — certainly lower than the potential growth rate of most economies (Chart 14). Theoretically, when GDP growth exceeds the interest rate the government pays on its borrowings, the debt-to-GDP ratios will eventually converge to a stable level, even if the government keeps running a huge budget deficit.3 Chart 13Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Chart 14The Neutral Rate Is Lower Than The Potential Growth Rate In Most Economies Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave   The catch is that this “stable” level of the debt-to-GDP ratio could turn out to be very high. This would leave the government extremely vulnerable to any future change in interest rates. Specifically, if at some point the neutral rate were to rise above the trend growth rate of the economy – and the central bank were to align policy rates with the new higher neutral rate – the government’s borrowing costs would soar. The government would then need to cut spending and/or increase in taxes to make room for additional interest payments.4  The Inflation Solution What if highly indebted governments refuse to tighten fiscal policy? At that point, they would either have to: 1) allow debt levels to spiral out of control; 2) default on the debt; or 3) lean on their central banks to keep rates low. The first two options are unlikely to be politically feasible, implying that the third one would be chosen. By definition, the third option would entail keeping policy rates below their neutral level, or in other words, keeping monetary policy more stimulative than is necessary to maintain full employment and stable inflation. Eventually, this would result in rising inflation. In theory, the increase in inflation can be temporary and limited. Rising consumer prices will lift nominal GDP, causing the ratio of debt-to-GDP to decline. Once the ratio shrinks by enough, central banks could raise interest rates to a suitably high level in order to bring inflation back down. Unfortunately, in practice, the whole process of driving inflation up in order to erode the real value of a government’s bond obligations could be quite destabilizing. This would be especially the case if, as is likely, a period of high inflation leads to a significant repricing of inflation expectations. Long-Term Inflation Risk Is Underpriced Chart 15Long-Term Inflation Expectations Remain Very Depressed Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Investors are not too worried that inflation will accelerate anytime soon. The CPI swap market expects inflation to remain subdued for decades to come (Chart 15). This could turn out to be an erroneous assumption. While central banks do not want inflation to get out of hand, they would be happy for it to increase from current levels. After all, they have been obsessing about the zero-lower bound constraint for the better part of two decades. If inflation is, say, 4% going into a downturn, central banks could cut nominal rates to zero, taking real rates to -4%. That would be quite stimulative. Such a deeply negative real rate would not be achievable if inflation were running at 1% going into a downturn.  As noted above, heavily indebted governments would also prefer higher inflation to higher interest rates. The former would erode the real value of debt, while the latter would require that tax dollars be diverted from social program to bondholders. The Neutral Rate May Rise The catch is that for inflation to rise, the neutral rate has to increase well above current policy rates. Will that happen? Our guess is that such an outcome is more likely than most investors believe. For one thing the neutral rate itself depends on the stance of fiscal policy. Looser fiscal policy will generate more demand in the economy. Since one can think of the neutral rate as the interest rate that equalizes aggregate demand with aggregate supply, this implies that larger budget deficits will increase the neutral rate. If, as seems likely, we are entering an era where political populism promotes big budget deficits, this makes it more likely that economies will, at some point, overheat. Savings Glut May Dissipate The structural forces that have depressed the neutral rate over the past few decades could also abate, and perhaps even reverse course. Take the example of demographics. Starting in the mid-1970s, the ratio of workers-to- consumers – the so-called “support ratio” – began to steadily increase as more women entered the labor force and the number of dependent children per household declined (Chart 16). An increase in the number of workers relative to consumers is equivalent to an increase in the amount of production relative to consumption. A rising support ratio is thus deflationary. More recently, however, the global support ratio has begun to decline as baby boomers leave the labor force in droves. Consumption actually increases in old age once health care spending is included in the tally (Chart 17). As populations continue to age, the global savings glut could dissipate, pushing up the neutral rate of interest in the process. Chart 16The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling Chart 17As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate Meanwhile, globalization, a historically deflationary force, remains on the backfoot. The ratio of global trade-to-output has been flat for over a decade (Chart 18). Globalization took a beating from last year‘s trade war, and is taking another bruising from the pandemic, as more companies relocate production back home in order to gain greater control over their supply chains. It is possible that newfangled technologies will allow companies to cut costs, thereby helping them to bring down prices. But, so far, this remains more a hope than reality. As Chart 19 shows, productivity growth in the major economies remains abysmal. Weak supply growth would slow income gains, potentially leading to a depletion of excess savings. Chart 18The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade Chart 19Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal   Social Unrest Continued social unrest could further disrupt the supply side of the economy. Violent crime has already spiked in a number of major US cities,5 just as it did five years ago in the aftermath of demonstrations in cities such as Baltimore and St. Louis (the US homicide rate rose 23% between 2014 and 2016, partly because police pulled out of many troubled neighbourhoods6). Markets generally ignored the social unrest back then, and they may do so again over the coming months. However, if recent developments herald the beginning of an extended crime wave, this could have momentous implications for asset markets. The number of people institutionalized in prisons and mental hospitals dropped dramatically during the 1960s. This corresponded with a sharp increase in the homicide rate (Chart 20). As violent crime soared, equity valuations dropped. Inflation also accelerated, hurting bondholders in the process (Chart 21). If a country cannot credibly commit to protecting its citizens, it is reasonable to wonder if it can credibly commit to maintaining price stability. Chart 20Dramatic Drop In Institutionalizations During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 21Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s As we discuss in greater detail below, the implication is that the long-term outlook for stocks and bonds is unlikely to be as rosy as the cyclical (3-to-12 month) outlook. III. Investment Implications For Now, Buy The Dip As anyone who has watched a horror movie knows, that scariest part of the film is the one before the monster is revealed. No matter how good the makeup or set design, our imaginations can always fathom something much more frightening than Hollywood can create. COVID-19 is a deadly disease, much deadlier than the common flu. But, at this point, it is a “known known.” The next few weeks will bring news reports of overflowing emergency rooms in some US states, delayed reopenings, and increased talk of renewed lockdowns. The knee-jerk reaction among investors will be to sell stocks. While that was the right trade in March, it may not be the right trade today, at least not for very long. Chart 22Betting Markets Now Expect Joe Biden To Become President Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave At this point, we know how the movie will end. As was the case during the first wave, the latest outbreak will be brought under control through a combination of increased voluntary social distancing and the cessation of activities that are known to significantly contribute to the spread of the disease (allowing bars and nightclubs to reopen was, as many predicted, a huge mistake). Likewise, while the next few weeks could see plenty of posturing among politicians in Washington, the end result will be a deal to avert most of the fiscal cliff. Investors who run for the hills now will end up making the same mistake as those who jettisoned stocks every time the debt-ceiling issue came to the fore in the past. Panicking about the outcome of November’s US presidential election would also be unwise. Yes, if Joe Biden wins and the Democrats take control of the Senate, then Trump’s corporate tax cuts would be in jeopardy. A full repeal would reduce S&P 500 EPS by about 12%. However, the betting markets are already expecting the Democrats to win the White House and Senate (Chart 22). Thus, some of this risk is presumably already priced in. Moreover, it is possible that the Democrats only partially reverse the corporate tax cuts, focusing more on closing some of the more egregious loopholes in the tax code. And even if corporate tax rates do rise, spending would likely rise even more, resulting in a net increase in fiscal stimulus. Lastly, a Biden presidency would result in less trade tension with China, which would be a welcome relief for equity investors. Are Stocks Already Pricing In A Benign Scenario? Chart 23Earnings Optimism Driven By Tech And Health Care Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Bottom-up estimates foresee S&P 500 earnings returning to 2019 levels next year. Does this mean that Wall Street analysts are banking on a V-shaped recovery? Not quite. Outside of the health care and technology sectors, EPS is still expected to be down 9% next year relative to 2019 (Chart 23). Globally, earnings estimates are still fairly downbeat. This suggests that analysts are expecting more of a U-shaped recovery. Of course, what matters to investors is not so much what analysts expect but what the market is pricing in. Given that the S&P 500 is down only 4% year-to-date, have investors gotten ahead of themselves? Again, it is not clear that they have. The value of the stock market does not simply depend on expected earnings growth. It also depends on the discount rate one uses to calculate the present value of future earnings. In a world of exceptionally low interest rates, the contribution from earnings far out into the future to this present value calculation is almost as important as the path of earnings over the next year or two. Provided that the pandemic does not permanently impair the supply-side of the economy, the impact on earnings should be transitory. In contrast, if long-term bond yields are any guide, the impact on the discount rate may be longer lasting. The 30-year US TIPS yield, a proxy for long-term real rate expectations, has fallen by 76 basis points since the start of the year, representing a significant decline in the risk-free component of the discount rate (Chart 24). If we put together analysts’ expectations of a temporary decline in earnings with the observed decline in real bond yields, what we get is an increase in the fair value of the S&P 500 of about 15% since the start of the year (Chart 25). Chart 24The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate Admittedly, the notion that there could be a temporary decline in corporate earnings but a permanent decline in bond yields sounds contradictory. However, it need not be. Imagine a situation where the pandemic does permanently reduce private demand, but that this is fully counteracted by looser monetary policy and increased fiscal stimulus. The result would be the same level of GDP but a lower interest rate.7 As odd as it sounds, this suggests that the pandemic might have increased the fair value of the stock market. Chart 25The Present Value Of Earnings: A Scenario Analysis Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Lots Of Cash On The Sidelines Chart 26Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around The combination of surging government transfers and subdued household spending has resulted in a jump in personal saving. Accumulated US personal savings totalled $1.25 trillion in the first five months of the year, up 123% from the same period last year. Much of that money has made its way into savings deposits and money market funds (Chart 26). As a share of stock market capitalization, US cash holdings currently stand at 51%, up nearly 12 percentage points from the start of the year. Looking at it differently, if the ratio of cash holdings-to-stock market capitalization were to return to January 1st levels, stocks would have to rise by about 30%. Retail Bros Versus The Suits Thanks to a steady flow of income from Uncle Sam, plenty of spare time, zero brokerage commissions, and a lack of opportunities for sports betting, the popularity of day trading has surged (Chart 27). It would be easy to dismiss the rise of the “retail bros” as another comical, and ultimately forgettable, chapter in financial history. That is what most have done. Not us. The late 1990s stock market bubble was as much a consequence of the boom in day trading as the cause of it. That boom lasted for more than four years, taking the S&P 500 to one record high after another. The current boom has lasted less than four months. It may have much further to run. Chart 27Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Keep in mind that every time an institutional investor sells what they regard as overpriced shares to a retail trader, the institutional investor is left with excess cash that must be deployed elsewhere in the stock market. Buying begets buying. Then there are the hedge funds. Brokerages like Robinhood make much of their money by selling order flow data to hedge funds, who then trade on this information. This activity probably lifts prices by enhancing liquidity and reinforcing the price momentum generated by retail trades.  One would also be remiss not to point out that the mockery levelled at retail traders has an aura of hypocrisy to it. The average mutual fund underperforms its benchmark, even before fees are included. As we discussed before, this is not because active managers cannot outperform the market.8 It is because most don’t even bother to try. In contrast to retail traders, a large fraction of institutional investors did not participate in the stock market recovery that began in late March. According to the latest BoA Merrill Lynch Survey, fund managers were still more than one sigma underweight stocks and nearly one sigma overweight cash in June. Along the same vein, speculators increased short positions in S&P 500 futures contracts soon after stocks rallied, paring them back only recently (Chart 28). As of last week, bears exceeded bulls by 25 percentage points in the AAII survey (Chart 29). When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.   Chart 28Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Chart 29Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks The bottom line is that stocks could fall another 5%-to-10% from current levels to about 2850 on the S&P 500 and 68 on the ACWI ETF but are unlikely to go much lower, as investors start to anticipate a peak in the number of new cases and a deal to maintain adequate levels of fiscal support. Start Of The Dollar Bear Market A weaker dollar should also help global equities (Chart 30). After peaking in March, the broad trade-weighted US dollar has fallen by 4.4%. Unlike last year, the dollar no longer benefits from higher US interest rates. Indeed, US real rates are below those of many partner countries due to the fact that US inflation expectations are generally higher than elsewhere (Chart 31). Chart 30A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities Chart 31The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 32). If global growth recovers over the coming quarters, the dollar should weaken. The negative pressure on the dollar may be amplified by the fact that the second wave of the pandemic seems likely to affect the US more than most other large economies. Chart 32The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Commodities And Commodity Currencies To Benefit Once fears of a second wave abate, the combination of stronger global growth, infrastructure-intense Chinese stimulus, and a weaker dollar will also boost commodity prices (Chart 33). BCA’s commodity strategists remain particularly fond of oil. They expect demand to pick up gradually this year, with supply continuing to be curtailed by shut-ins among US producers and production discipline from OPEC and Russia. Their latest projections foresee WTI and Brent prices rising more than 50% above current market expectations in 2021 (Chart 34). Chart 33Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 34Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Higher oil prices will be particularly beneficial to currencies such as the Norwegian krone, Canadian dollar, Mexican peso, Colombian peso, and Malaysian ringgit. A Weaker Dollar Will Support Non-US Stocks Stronger global growth, a weaker dollar, and higher commodity prices will disproportionately help the more cyclical sectors of the stock market (Chart 35). Since cyclical stocks tends to be overrepresented outside the US, non-US equities should outperform their US peers over the next 12 months. A weaker dollar will also reduce the local-currency value of dollar-denominated debt. This will be especially helpful for emerging markets. Despite the recent rally, the cyclically-adjusted PE ratio for EM stocks remains near historic lows (Chart 36). EM equities should fare well over the next 12 months. Chart 35Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Chart 36EM Stocks Are Cheap Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 37Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Chart 38Expected Earnings Recovery: US Lags Slightly Behind Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave More broadly, non-US stocks look quite attractive in both absolute terms and in relation to bonds compared to their US peers (Chart 37). They are also unloved. In the BofA Merrill Lynch survey mentioned above, equity managers are heavily overweight the US, despite the fact that consensus earnings estimates point to a slightly faster recovery in EPS outside the United States (Chart 38). Thus, earnings trends, valuations, and sentiment all currently favor non-US stocks. Bond Yields To Stay Subdued… For Now It will probably take a couple of years for the unemployment rate in the G7 to fall to pre-pandemic levels. It will likely be another year or two before labor markets tighten to the point where inflation takes off. And, as discussed above, even if inflation does rise, central banks will be slow to raise rates both because they want higher inflation and because governments will pressure them to keep rates low in order to avoid having to redirect tax revenue from social programs to bondholders. All this suggests that short-term rates could remain depressed across much of the world until the middle of the decade. Chart 39Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Yield curves will steepen marginally over the next few years as global growth recovers and long-term bond yields rise in relation to short-term rates. In absolute terms, however, long-term yields will remain low. An initial bout of higher inflation will not be enough to lift long-term yields to a significant degree given the ability of central banks to cap yields via the threat of unlimited bond purchases – something that Japan and Australia are already doing. Yields will only rise substantially when central banks start feeling uneasy about accelerating inflation. As noted above, that point is probably still 3-to-5 years away. But, when it does come, it will be very painful for bondholders and equity holders alike. Not Much Scope For Further Spread Compression Spreads are unlikely to widen much in a low-rate, higher growth environment. Nevertheless, one should acknowledge that spreads are already low and corporate debt levels were quite elevated going into the recession, especially among companies with publicly-traded bonds (Chart 39). As such, while we generally favor a pro-risk stance over the next 12 months, we would recommend only benchmark exposure to high-yield credit. Within that category, we would favor consumer credit or corporate credit. We would especially shy away from credit linked to urban office and brick-and-mortar retail shopping, given the unfavorable structural shifts in those sectors.  Gold Is Still Worth Owning Chart 40Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Lastly, a few words on gold. We upgraded our view on gold in late March. A weaker dollar will boost gold prices over the next 12 months, while higher inflation down the road makes gold an attractive hedge. Yes, the real price of gold is elevated relative to its long-term history (Chart 40). However, gold prices were distorted during most of the 20th century as one country after another abandoned the gold standard. The move to fiat money eliminated the need for central banks to hold large amounts of gold, which reduced underlying demand for the commodity. Had this move not happened, the real price of gold – just like the price of other real assets such as property and art – would have risen substantially. Thus, far from being above their long-term trend, gold prices could still be well below it. Our full suite of tactical, cyclical, and structural market views are depicted in the matrix below. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020. 2  For those unfamiliar with Saturday morning cartoons, Wile E. Coyote is a devious and scheming Looney Tunes cartoon character usually depicted unsuccessfully attempting to catch his prey, the Road Runner. Wile E. Coyote is outwitted each time by the fast-running bird, but fails to learn his lesson and tries anew. One popular gag involves the coyote running off a cliff, stopping mid-air to look down, only to realize that there is no more road beneath him. 3 This is a tricky point to grasp, so it might be helpful to think through an example. Suppose that government debt is 100 and GDP is also 100. Let us assume that the interest rate is 1%, trend growth is 3%, and the government wishes to run a primary budget deficit of 5% of GDP (the primary deficit is the deficit excluding interest payments). It does not matter if the interest rate and growth are expressed in nominal terms or real terms, as long as we consistently use one or the other. Initially, the debt-to-GDP ratio is 100%. The following year, debt increases to 100+5+100*0.01=106, while GDP rises to 103. Hence, the debt-to-GDP ratio jumps to 106/103=102.9%. The debt-to-GDP ratio will keep rising until it reaches 250%. At that point, debt-to-GDP will stabilize. To see why, go back to the original example but now assume that debt is 250 while GDP is still 100. The following year, debt increases to 250+5+250*0.01=257.5, while GDP, as in the first example, rises to 103. 257.5 divided by 103 is exactly 250%. 4 The standard equation of debt sustainability, which we derived in Box 1 of the Global Investment Strategy Weekly Report titled “Is There Really Too Much Government Debt In The World?”, says that the ratio of government debt-to-GDP will be stable if the primary budget balance (expressed as a share of GDP), p, is equal to the debt-to-GDP ratio (D/Y) multiplied by the difference between the interest rate and the growth rate of the economy, that is, p=D/Y (r-g). When p>D/Y (r-g), debt-to-GDP will fall. When, p<D/Y (r-g), debt-to-GDP will rise. Note that the higher the debt-to-GDP ratio is at the outset, the more the primary budget surplus would need to increase in response to a rise in interest rates.  5 Please see Ashley Southall and Neil MacFarquhar, “Gun Violence Spikes in N.Y.C., Intensifying Debate Over Policing,” The Wall Street Journal, dated June 23, 2020; “Gun Violence Soars in Minneapolis,” WCCO/CBS Minnesota, dated June 22, 2020;  and Tommy Beer, “18 People Were Murdered In Chicago On May 31, Making It The City’s Single Deadliest Day In 60 Years,” Forbes, dated June 8, 2020. 6 Please see “Baltimore Residents Blame Record-High Murder Rate On Lower Police Presence,” npr.org, dated December 31, 2017. 7 For economics aficionados, one can model this as a permanent inward shift of the IS curve and permanent outward shift of the LM curve which leaves the level of GDP unchanged but results in lower equilibrium interest rate. 8 Please see Global Investment Strategy Special Report, “Quant-Based Approaches To Stock Selection And Market Timing,” dated November 9, 2018. Global Investment Strategy View Matrix Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Current MacroQuant Model Scores Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave

Highlights Should the DXY fail to breach below 92 in the coming months, momentum will be a risk to our short dollar positions. Another risk is valuation. The trade-weighted dollar is expensive, but not overly so. It is not especially expensive versus the euro and some commodity currencies. A post-COVID-19 world in which global economies become more closed could also hurt short dollar positions. Maintain a barbell strategy, being long a basket of the cheapest currencies (SEK and NOK) together with some safe havens (JPY). This should insulate portfolios over what could become a more volatile summer. Feature Chart I-1The Dollar And Markets The Dollar And Markets The Dollar And Markets The breakdown in the dollar since March is still facing some skepticism, even internally at BCA. As a reserve currency, the dollar tends to do well during periods of heightened uncertainty. With a clear risk of a second COVID-19 infection wave, and with equity markets up strongly from their lows, odds are that volatility could rise in the near term. Renewed geopolitical tensions between China and the US as well as the upcoming US presidential election are also sources of risk. Historically, the dollar has tended to rise with both increasing equity and geopolitical risk premia (Chart I-1). The key question is whether any near-term bounce in the dollar is technical in nature, or represents the resumption of the bull market. While the dollar is a countercyclical currency, it has also been in a bull market since 2011, notwithstanding the growth upcycles that took place during that period. Through a series of technical, valuation, and macroeconomic charts, we will explore the key risks to our dollar-bearish view as well as potential signposts to see if we are spot on in our thinking. The Long-Term Technical Profile Is Bullish Chart I-2The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles The dollar is a momentum currency, and so tends to move in long cycles. Moreover, in recent history, these cycles have tended to last around eight to 10 years, coinciding with the NBER definition of business cycles. The dollar bear market of the 1980s entered its capitulation phase with the 1990s recession. Similarly, the dollar bull market of the late ‘90s ended with the 2001 recession. The Great Recession in 2008 and subsequently cascading crises from the Eurozone to Japan in 2010-2011 ended the bear market run in the dollar from 2001. If the past is prologue, then the pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. There is also an economic reason for the decade-long run in dollar cycles. This is the time it usually takes to build and subsequently unwind imbalances in the US economy. In a closed economy, savings must equal investment. However, in open economies, investors usually require a cheaper exchange rate (or higher interest rates) to fund rising deficits, just as they require a higher IRR to fund projects with risky cash flows. This has been the story for the US dollar since the 1980s (Chart I-2). Of course, dollar transition phases can be quite volatile, and the risk to this view is that the dollar bear story could be one for 2022 rather than 2020. However, it is also noteworthy that dollar tops are generally V-shaped, while bottoms are more saucer-shaped. The reason is that the Federal Reserve is usually at the center of a dollar peak, in its decisiveness to ease monetary conditions quite aggressively. At bottoms, the dollar is typically already sufficiently cheap that it does not pose headwinds to the US economy. The pandemic recession of 2020 may also be signaling an end to the dollar’s decade-long bull run. If the DXY can easily break through  the 92-94 zone, this will technically end the bull market in place since 2011, as the powerful upward-sloping channel, in place since then, will be breached (Chart I-3). On the sentiment side of things, conditions remain bullish, which is positive from a contrarian perspective. Professional forecasters often tend to be  adaptive, with a Bloomberg survey expecting the DXY to be flat by year end, but hitting 92 only in 2022 (Chart I-4). More importantly, they tend to miss important turning points in the greenback. Chart I-3A Technical Profile For DXY A Technical Profile For DXY A Technical Profile For DXY Chart I-4The Dollar And Forecasters The Dollar And Forecasters The Dollar And Forecasters The Dollar Is Not Overly Expensive The valuation picture for the dollar is more nuanced, and is our biggest source of risk. The dollar is clearly expensive versus currencies such as the Swedish krona and Norwegian krone, but on a trade-weighted basis, the dollar is only one standard deviation above our fair-value model. This still makes the dollar pricey, but not to the extent of previous peaks, that have tended to occur around two standard deviations above fair value (Chart I-5). Our long-term fair value model has two critical inputs – the productivity gap between the US and its trading partners as well as real bond yield differentials. Rising productivity ensures a country can pursue non-inflationary growth. This lifts the neutral rate of interest in the country, raising the long-term fair value of its exchange rate. The Bloomberg survey expects the DXY to be flat by year end, but hitting 92 only in 2022. Since 2010, the productivity gap between the US and its trading partners has been flat, but there is reason to believe this gap will start to roll over. For one, fiscal largesse could crowd out private investment. But more importantly, as my colleague Ellen JingYuan He of BCA’s Emerging Market Strategy reckons, productivity gains in countries like China could start to pick up as it becomes a world leader in innovation (Chart I-6). This will allow real bond yields outside the US to remain high. Chart I-5The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive Chart I-6US Relative Productivity May Decline US Relative Productivity May Decline US Relative Productivity May Decline The key point is that valuation alone is not a sufficient catalyst for dollar short positions, which is a risk to the view. This is especially the case versus commodity currencies and the euro. That said, there are still some currencies trading below or near two standard deviations from their mean relative to the US dollar. This includes the NOK, SEK, and to a certain extent the GBP (Chart I-7). We remain long these currencies in our portfolio. Chart I-7ASome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Chart I-7BSome G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap Some G10 Currencies Are Very Cheap   Post COVID-19 Behavior Could Be Dollar Bullish A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view. This is because when global growth is rebounding, more cyclical economies benefit from this growth dividend, and as such capital tends to gravitate to their respective economies. This is aptly illustrated with consumption being a much larger share of GDP in the US compared to exports (Chart I-8). A move towards more domestic production will hurt the capital flows that have tended to dictate the dollar’s countercyclical nature. A post COVID-19 world in which global economies become more closed could hurt the bearish dollar view.  Chart I-9 shows that dollar strength throughout most of March can be partly  explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. Once the initial snapback phase has been established, differentiation among economies will then begin Chart I-8The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization The US Economy Will Benefit From De-Globalization Chart I-9Relative Growth And ##br##The Dollar Relative Growth And The Dollar Relative Growth And The Dollar More importantly, in a post COVID-19 world, “platform” companies that can virtually leverage their technology and expertise across borders are replacing “brick and mortar” businesses that need both shipping lanes and ports to remain open. For example, will demand for autos ever recover to pre-crisis levels, when one can video conference rather than drive for two hours to the office? In general terms, if deep value stocks cannot find a way to improve their return on capital, flows into these markets (heavily represented outside the US), will dwindle. This will be a key risk to the dollar bearish view (Chart I-10).   Chart I-10Deep Value And The Dollar Deep Value And The Dollar Deep Value And The Dollar That said, manufacturing renaissances do happen. Asia, for example, remains at the core of both robotic and semiconductor manufacturing, which are redefining the production landscape. And over the long term, valuations do matter – and the starting point for US equities is unfavorable. Strategy And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP, along with some safe havens. Our list of trades is printed on page 9. We were stopped out of our short gold/silver position and are reinstating that trade today. While gold does better than silver during market riots, the ratio is 100:1, which is the most overvalued it has been in over a century. Once retail participation gains hold of cheap silver prices, which usually occurs during latter parts of precious metal bull markets, the move could be explosive. We remain long the pound, but are respecting our stop on our short EUR/GBP position that was triggered last week. Valuation supports the pound but politics will increase near-term volatility. We are raising our limit sell to 0.92, which has provided tremendous resistance since the referendum in 2016. Finally, the correction in energy prices is providing an interesting entry point for both the NOK/SEK cross and petrocurrencies. We remain oil bulls on the back of a pickup in global demand. This should lead to the outperformance of energy stocks, benefiting inflows into the CAD, NOK, RUB, MXN, and COP.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been mostly positive: The Markit manufacturing PMI rebounded to 49.6 from 39.8 in June. The services PMI and composite PMI both increased to 46.7 and 46.8, respectively. The Chicago Fed National Activity index increased from -17.89 to 2.61 in May. Existing home sales fell by 9.7% month-on-month in May. However, new home sales surged by 16.6% month-on-month. Initial jobless claims increased by 1480K for the week ended June 19th, higher than the expected 1300K. The DXY index increased by 0.34% this week. Recent data have shown some improvement in the economy, supported by the reopening and Fed’s unprecedented relief measures. We remain cautiously bearish on the US dollar. Please refer to our front section this week for a checklist of risks to the bearish dollar view. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit manufacturing PMI increased from 39.4 to 46.9 in June. The services PMI increased to 47.3 from 30.5 and the composite PMI ticked up from 31.9 to 47.5. The current account surplus shrank from €27.4 billion to €14.4 billion in April. Consumer confidence slightly improved from -18.8 to -14.7 in June. The euro fell by 0.5% against the US dollar this week. The ECB decided to offer euro loans against collateral to central banks outside the euro area during the pandemic. Besides, the Eurosystem repo facility for central banks (EUREP) will remain available until the end of June 2021. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been negative: The manufacturing PMI fell from 38.4 to 37.8 in June. The coincident index fell from 81.5 to 80.1 in April, while the leading economic index ticked up from 76.2 to 77.7. The All Industry Activity Index fell by 6.4% month-on-month in April. The Japanese yen depreciated by 0.5% against the US dollar this week. The BoJ Summary of Opinions released this week pointed out that Japan’s economy has been in an extremely severe downturn and the recovery is likely to be longer and slower. Moreover, the BoJ has expressed concerns that Japan might slip back into deflation. We are long the yen as portfolio insurance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit manufacturing PMI increased from 40.7 to 50.1 in June. The services PMI also soared from 29 to 47. Retail sales fell by 13.1% year-on-year in May. However, it increased by 12% compared to the previous month.  The British pound fell by 0.7% this week. Last week, the MPC voted unanimously to keep the current rate unchanged at 0.1%. The Committee also voted by a majority of 8-1 for the Bank to increase government bond purchases by another £100 billion, bringing the total purchases to £745 billion. However, governor Andrew Bailey also indicated in a Bloomberg Opinion article on Monday that the Bank might take measures to reduce the BoE’s swollen balance sheet, indicating the £100 billion might be the last should conditions improve. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: The manufacturing PMI increased from 44 to 49.8 in June. The services PMI soared from 26.9 to 53.2, bringing the composite PMI up to 52.6 in June. The Australian dollar initially rose against the US dollar, then fell, returning flat this week. During an online panel discussion this week, the RBA Governor Lowe warned about the long-lasting impact of the COVID-19. More importantly, he said that at the current level close to 0.7, the Australian dollar is not overvalued against the US dollar, even though a lower currency would support exports and push the inflation back to target. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Exports declined by 6.1% year-on-year to NZ$5.4 billion in May, mainly due to lower sales in logs, fish, machinery and equipment. In contrast, exports of dairy products increased by 4.5% year-on-year. Imports slumped by 25.6% year-on-year, led by lower purchases of vehicles and petroleum products. The trade surplus fell to NZ$ 1.25 billion in May from NZ$ 1.34 billion in April. However, this compares favorably with a trade deficit of NZ$ 175 million in the same month last year. The New Zealand dollar fell by 0.6% against the US dollar this week. On Wednesday, the RBNZ held its interest rate unchanged at 0.25% as widely expected and maintained its current pace of QE. However, the Bank sounded quite dovish and indicted that it is ready to further ease policy whenever needed. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: Preliminary data shows that retail sales rebounded by 19.1% month-on-month in May, following a 26.4% decrease the previous month. The Canadian dollar depreciated by 0.7% against the US dollar this week. In his first speech as Bank of Canada Governor this week, Tiff Macklem warned that the recovery might be longer than expected, and indicated that the Bank needs a quick response and targeted containment to fight possible future waves of COVID-19 and another round of a broad-based shutdown. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The ZEW expectations index rose from 31.3 to 48.7 in June. Money supply (M3) surged by 2.5% year-on-year in May. Total sight deposits increased to CHF 680.1 billion from CHF 679.5 billion for the week ended June 19th. The Swiss franc appreciated by 0.2% against the US dollar this week. The SNB Quarterly Bulletin in Q2 was released this week and it showed that while government loans have been helpful to support the economy, the declines in profit margins were exceptionally severe. Moreover, a further appreciation of the Swiss franc remains a downside risk for a small open economy like Switzerland. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: The unemployment rate increased to 4.2% in April from 3.6% the previous month. The Norwegian krone fell by 1% against the US dollar this week, along with lower oil prices. Last week, the Norges Bank left its interest rate unchanged at 0% and signaled that the rates are set to remain at current levels over the next few years. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence increased from 77.7 to 84 in June. The Swedish krona appreciated by 1.2% against the US dollar this week. As one of the few countries without strict lockdown measures, Sweden’s business sectors are showing budding signs of recovery in May and June, according to a company survey by the central bank. However, most companies believe that the recovery would take at least 9 months or longer. On another note, the Riksbank has been testing its digital currency e-krona and might be the first central bank to implement the wide use of digital currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

US Dollar Bear Market... US Dollar Bear Market... In this Monday’s Special Report, we examined which S&P 500 GICS1 sectors have historically benefited from a falling greenback. Currently, piling evidence suggests that the path of least resistance will be lower for the US dollar. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (top panel), but now the US Congressional Budget Office (CBO) estimates that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020 if not higher. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 catalyzed recession and resulting money printing will likely exert extreme downward pressure on the US dollar (bottom panel).  

Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine.   Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region Brazil: Is The Worst Behind Us? Brazil: Is The Worst Behind Us?   While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Household Income, Credit And Debt Service Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth   Chart I-7The Social Security Deficit Is Widening The Social Security Deficit Is Widening The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Inflation Is Undershooting Inflation Is Undershooting Chart II-2Wage Growth Is Subdued! Wage Growth Is Subdued! Wage Growth Is Subdued!   As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume Foreign Inflows Could Resume Foreign Inflows Could Resume   With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Current Account Will Balance Soon Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves   Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months.  EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The Rally Is Underpinned The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions Exploding Liquidity Conditions Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII July 2020 July 2020 The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left July 2020 July 2020 Chart I-6The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There July 2020 July 2020 Chart I-7Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes European Hopes European Hopes Chart I-9Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound July 2020 July 2020 … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave A Different Wave A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break A Needed Digestive Break A Needed Digestive Break Chart I-15Bonds Are Pricey... Bonds Are Pricey... Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message Sweden's Message Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Bearish Dollar Backdrop Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Banks Are Cheap Banks Are Cheap Chart I-22Banks As A Contrarian Bet Banks As A Contrarian Bet Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks Favor Foreign Stocks Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Attractive EM Valuations Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Japanese Stocks As A Trade Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle The End Of The Debt Super Cycle The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Little Room To Cut Taxes Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth July 2020 July 2020 Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds July 2020 July 2020 The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best ...But Gold Looks The Best ...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism July 2020 July 2020 Chart II-3USA: From Nationalism To Anti-Nationalism July 2020 July 2020   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession July 2020 July 2020 Chart II-5World Conflicts Rise After Major Crises July 2020 July 2020   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism July 2020 July 2020 Chart II-9US And EU Crack Down On Immigration July 2020 July 2020   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count July 2020 July 2020 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020 Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War July 2020 July 2020 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance July 2020 July 2020 Chart III-8Global Stock Market And Earnings: Relative Performance July 2020 July 2020   FIXED INCOME:   Chart III-9US Treasurys And Valuations July 2020 July 2020 Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

The Fed’s efforts to jawbone the US dollar are paying off as investors have been shedding their greenback exposure over the past several weeks. In recent research,1 we have also been highlighting that although Powell would never admit it, the Fed is trying to devalue the greenback and reflate the global economy. The knock-on effect of a depreciating USD is to rekindle S&P sales. According to S&P Dow Jones Indices,2 the SPX derives approximately 43% of its sales from abroad making the US dollar among the key macro profitability drivers (Chart 1, middle panel, US dollar shown advanced and inverted). One of the mechanisms to undermine the greenback is to flood the market with dollars. Ample US dollar based liquidity has historically served as a catalyst to reignite global growth and consequently S&P earnings (Chart 1, bottom panel). Chart 1US Dollar - The Key Driver US Dollar - The Key Driver US Dollar - The Key Driver Chart 2Bearish Across All Timeframes Bearish Across All Timeframes Bearish Across All Timeframes The Dollar: A Bearish Case The fate of the US dollar is yet to be sealed, but piling evidence suggests that the path of least resistance will be lower. Looking at structural (five years+) dynamics, swelling twin deficits emit a bearish USD signal. In more detail, prior to COVID-19 outbreak, the US twin deficits were estimated to gradually rise towards the 7.5% mark (Chart 2, top panel, dotted red line), but now the US Congressional Budget Office (CBO) estimates3 that the US fiscal deficit alone will be approximately 11% of nominal GDP for 2020. In other words, the recent pandemic has exacerbated already structurally bearish dynamics for the US dollar. Switching gears from a structural to a medium term horizon (2-3 years), BCA’s four-factor macro model, is sending an unambiguous bearish message regarding the greenback’s fate (Chart 2, middle panel). Finally, on a short-term time horizon, the USD is lagging the money multiplier by approximately 3 months. The COVID-19 induced recession and resulting money printing will likely exert extreme downward pressure on the US dollar (Chart 2, bottom panel). Summarizing, when looking across three different time horizons, the evidence is pointing toward a weakening US dollar for the foreseeable future. SPX Sectors And US Dollar Correlations With a rising probability of a US dollar bear market on the horizon, it pays to look back in time and examine which S&P GICS1 sectors benefited from a depreciating US dollar. The purpose of this Special Report is to shed light on the empirical evidence of SPX sectors and USD correlations and serve as a roadmap of sector winners and losers during USD bear markets. Table 1 provides foreign sales exposure for each of the sectors. All else equal, a falling greenback should be synonymous with technology, materials, and energy sectors outperforming as they are the most internationally exposed sectors. In contrast, should the USD change its course and head north, financials, telecom, REITs, and utilities will be the key beneficiaries. Why? Because most of these industries are landlocked in the US and thus in a relative sense should benefit when the US dollar roars. Table 1S&P 500 GICS1 Foreign Sales As A Percent Of Total Sales* US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell To confirm the above hypothesis, we have identified three previous US dollar bear markets (Chart 3) and computed GICS1-level sector relative returns (Table 2). Chart 3US Dollar Bear Markets US Dollar Bear Markets US Dollar Bear Markets Table 2S&P 500 Gics1 Returns* During US Dollar Bear Markets US Dollar Bear Market: What To Buy & What To Sell US Dollar Bear Market: What To Buy & What To Sell Looking at median return profile reveals that our hypothesis held as all three: technology, materials, and energy decisively outperformed the market when the US dollar headed south. Similarly, domestically focused and predominately defensive industries such as utilities and telecoms underperformed the market with the consumer staples sector being a notable outlier – something that we address in the consumer staples section of the report. What follows next is a detailed discussion on each of the GICS1 sectors historical relationship with the US dollar, ranked in order of foreign sales exposure from highest to lowest. For completion purposes, we also provided S&P 500 GICS1 relative sector performance against the US dollar charts since 1970 in the Appendix.     Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Technology (Neutral)  Technology sits atop the foreign sales exposure table garnering 58% of revenues from abroad, which is a full 15% percentage points higher than S&P 500 (Table 1). In two out of the three periods of USD bear markets that we examined, tech stocks bested the broad market and the median outperformance sat over 9%. Nevertheless, the correlation between the US dollar and relative share prices is muted over a longer-term horizon (see Appendix Chart A1 below). Likely, one reason for the inconclusive long-term correlation between tech and the greenback is that the majority of tech gadgets are manufactured overseas (Chart 4, third panel). Therefore, an appreciating currency boosts margins via deflating input costs. Tack on the resilient nature of demand for tech hardware goods and especially software and services which preserves high selling prices and offsets and negative P&L losses from a rising greenback. We are currently neutral the S&P technology sector and employ a barbell portfolio approach preferring software and services and avoiding hardware and equipment. Chart 4Technology Technology Technology Materials (Neutral) The materials sector behaves similarly to its brother the energy sector as both move in the opposite direction of the greenback (Chart 5, top panel). Consequently, materials stocks have outperformed the market during periods of US dollar weakness that we analyzed. The third panel of Chart 5 shows that our materials exports proxy is the flip image of the greenback. This tight inverse relationship is exacerbated by the negative impact of a firming dollar on underlying metals commodity prices (Chart 5, second panel). As a result, materials profit margins widen when the dollar falls and narrow when it rises. Ultimately, S&P materials earnings reflect this USD-commodity dynamic (Chart 5, bottom panel) We are currently neutral the S&P materials index. Chart 5Materials Materials Materials Energy (Overweight) The energy sector enjoys a tight inverse correlation with the US dollar (Chart 6, top panel) as it is the third most globally exposed sector as shown in Table 1 with 51% of sales coming from abroad. As nearly all of the global oil trade is conducted in US dollars, a weakening USD underpins the price of crude oil (Chart 6, second panel). In turn, US energy sector exports rise reflecting the fall in the greenback (Chart 6, third panel). Finally, the S&P energy companies enjoy a boost to their income statements (Chart 6, bottom panel), which explains the sizable median sector outperformance of 43% during dollar bear markets as highlighted in Table 2. We are currently overweight the S&P energy sector and have recently capitalized on 40%+ combined gains in the long XOP/short GDX pair trades.4 Chart 6Energy Energy Energy Industrials (Overweight) US industrials stocks’ foreign sales exposure is on a par with the S&P 500, which explains why the sector only barely outperformed the broad market during periods of dollar weakness. Still, the correlation between this manufacturing-heavy sector and the greenback is negative (Chart 7, top & second panels). Similar to its deep cyclical brethren (materials and energy), the link comes via the commodity channel. A softening dollar boosts global growth, which in turn supports higher commodity prices. Not only do US capital goods producers benefit from overall rising demand (i.e. infrastructure spending), but also via market share gains in global markets as the falling greenback results in a comparative input cost advantage (Chart 7, third panel). Finally, P&L translation gain effects act as another fillip to industrials stocks profits when dollar heads south. We are currently overweight the S&P industrials index. Chart 7Industrials Industrials Industrials Health Care (Overweight) The defensive health care sector is positively correlated with the dollar as its foreign sales revenues are below the ones of the SPX (Chart 8, top panel). Moreover, empirical evidence suggests that the relationship between the sector’s exports and the USD has been mostly positive, which is counterintuitive (Chart 8, middle panel). Keep in mind that pharma and biotech represent roughly half the index and derive 75%+ of their profits domestically as they dictate pricing terms to the US government (it is written into law). This is not the case in Europe where the NHS and the German government for example, have a big say on what pharmaceuticals can charge for their drugs. The bottom panel of Chart 8 summarizes the domestic nature of the health care sector, highlighting the tight positive relationship between the sector’s earnings and the greenback. We are currently modestly overweight the S&P health care sector. Chart 8Health Care Health Care Health Care Consumer Discretionary (Overweight) While the impact of the US dollar on the consumer discretionary sector varied over time switching from a positive to a negative and vice versa, today the sector enjoys a positive correlation with the currency (Chart 9, top panel). The 33% foreign sales exposure may appear as a significant proportion, but it is still a full 10% percentage points below the SPX (Table 1). The implication is that even though the exports benefit from a falling dollar (Chart 9, middle panel), this bump is not enough to drive sector outperformance. Likely, the key reason why consumer discretionary stocks currently enjoy a positive correlation with the dollar is the US large trade deficit. In other words, the US imports the lion’s share of its consumer goods. As the dollar grinds higher, the cost of imports decreases for the US consumer, which provides a boost to companies’ earnings (Chart 9, bottom panel). Tack on the heavy weight AMZN has in the sector (comprising 40% of consumer discretionary sector market cap) and the positive correlation with the currency is explained away. We are currently overweight the S&P consumer discretionary index. Chart 9Consumer Discretionary Consumer Discretionary Consumer Discretionary Consumer Staples (Neutral) While a softening US dollar generally favors cyclical industries as it reignites global trade, the defensive S&P consumer staples sector outperformed the overall market on a median basis during USD bear markets (Table 2). Granted, the results are likely skewed as staples stocks rallied more than 300% in the last two decades of the 20th century. Nevertheless, there is a key differentiating factor at play that helped the consumer staples sector trounce other defensive industries during US dollar bear markets. Staples stocks derive 33% (Table 1) of their sales from abroad, whereas other traditional defensive industries (utilities, telecom services) have virtually no export exposure. In other words, given that staples companies are mostly manufacturers, a depreciating currency acts as a tonic to sales via the export relief valve (Chart 10, bottom panel). We are currently neutral the S&P consumer staples sector. Chart 10Consumer Staples Consumer Staples Consumer Staples Financials (Overweight) Financials sit at the bottom half of our Table 1 in terms of their foreign sales exposure, which underpins the sector’s positive correlation with the greenback (Chart 11, top panel), and explains why the sector underperforms the market during dollar bear markets. One of the transmission channels between this sector’s performance and the currency is via increased credit demand. Currency appreciation suppresses inflation and supports purchasing power, and thus loan demand, in addition to keeping bond yields low (Chart 11, middle panel). The process reverses as the US dollar stars to depreciate. We are currently overweight the S&P financials index. Chart 11Financials Financials Financials Utilities (Underweight) Utilities underperformed in all three dollar bear markets we analyzed. As we highlighted in the energy section of the report, a softening dollar is synonymous with higher crude oil prices, which in turn raise inflation expectations. The ensuing selloff in the 10-year Treasury, compels investors to shed this bond proxy equity sector (Chart 12, middle panel). With virtually no exports, utilities also miss on the positive currency translation effects that other GICS1 sectors enjoy. In fact, utilities underperformed by the widest margin on a median basis across all GICS1 sectors (Table 2). This defensive sector typically attracts safe haven flows when the dollar spikes and investors run for cover. This positive correlation with the dollar is clearly reflected in industry earnings, which rise and fall in lockstep with momentum in the greenback (Chart 12, bottom panel). We are currently underweight the S&P utilities sector. Chart 12Utilities Utilities Utilities Telecommunication Services (Neutral) Telecom services relative performance is positively correlated with the dollar, similarly to its defensive sibling, the utilities sector. In fact, telecom carriers go neck-in-neck with utilities as the former is the second worst performing sector during dollar bear markets (Table 2). A softening dollar has proven to be fatal to the industry’s relative pricing power beyond intra industry competition. In fact, industry selling prices are slated to head south anew if history at least rhymes (Chart 13, middle panel). Importantly, this defensive sector is in a structural downtrend and is trying to stay relevant and avoid becoming a “dumb pipeline” with the eventual proliferation of 5G. Worrisomely, telecoms only manage to claw back some of their severe losses during recessions. But, the latest iteration is an aberration as this safe haven sector has failed to stand up to its defensive stature likely owing to the heavy debt load. We are currently neutral the niche S&P telecom services index that now hides underneath the S&P communication services sector. Chart 13Telecom Services Telecom Services Telecom Services REITs (Underweight) Surprisingly, US REITs enjoy an overall negative correlation with the dollar, especially since 1993, and in fact lead the greenback by about 18 months (Chart 14). Our hypothesis would have been a positive correlation courtesy of the landlocked nature of this sector i.e. no export exposure. Granted, in the three periods of dollar bear markets we examined, REITs slightly outperformed the market by 2.5% on a median basis. While the causal link (if any) is yet to be established and the correlation may be spurious, our sense is that forward interest rate differentials are at work and more than offset the domestic nature of this index. REITs have a high dividend yield and thus outperform when the competing risk free asset the 10-year Treasury yield is falling and vice versa (except during recessions). As a result, REITs outperformance is more often than not synonymous with a depreciating currency as lower Treasury yields would exert downward pressure on the USD ceteris paribus.  We are currently underweight the S&P REITs index. Chart 14REITs REITs REITs   Appendix Chart A1Appendix: Technology Appendix: Technology Appendix: Technology Chart A2Appendix: Materials Appendix: Materials Appendix: Materials Chart A3Appendix: Energy Appendix: Energy Appendix: Energy Chart A4Appendix: Industrials Appendix: Industrials Appendix: Industrials Chart A5Appendix: Health Care Appendix: Health Care Appendix: Health Care Chart A6Appendix: Consumer Discretionary Appendix: Consumer Discretionary Appendix: Consumer Discretionary Chart A7Appendix: Consumer Staples Appendix: Consumer Staples Appendix: Consumer Staples Chart A8Appendix: Financials Appendix: Financials Appendix: Financials Chart A9Appendix: Utilities Appendix: Utilities Appendix: Utilities Chart A10Appendix: Telecommunication Services Appendix: Telecommunication Services Appendix: Telecommunication Services Chart A11 landscapeAppendix: REITs Appendix: REITs Appendix: REITs   Footnotes 1    Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2    https://us.spindices.com/indexology/djia-and-sp-500/sp-500-global-sales 3    https://www.cbo.gov/system/files/2020-05/56351-CBO-interim-projections.pdf 4    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.  

Highlights When retail investors invest aggressively and central banks buy assets en masse, economic fundamentals take the back seat and momentum becomes king. Global risk assets are at a fork in the road: either they will relapse meaningfully as they have run well ahead of fundamentals or a budding mania will push global share prices to fresh new highs.   A budding mania is the basis behind our strategy of chasing momentum from this point on. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Feature Chart I-1Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Make It Or Break It Moment For US Dollar Global share prices have reached a point where they are no longer oversold. In turn, the trade-weighted US dollar has worked out its overbought conditions and is sitting on major defensive lines (Chart I-1). If the dollar relapses below its technical resistances, it will enter a bear market. Consistently, EM risk assets will enter a bull market. The trajectory of EM risk assets and currencies in the coming months will ultimately depend on what happens to the ongoing global FOMO (fear-of-missing-out) rally. We refer to it as a FOMO rally because both the DM and EM equity rallies have been taking place despite deteriorating corporate profit expectations, as we documented in our June 4 report. Why The FOMO Rally May Still Have Legs There are a number of reasons why this FOMO-driven rally could persist: Chart I-2Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US First, the Federal Reserve is explicitly targeting higher asset prices, and to achieve this goal it is deploying its “nuclear” arsenal – printing money and monetizing public debt, lending to the private sector as well as buying corporate bonds. US broad money growth is at an all-time high (Chart I-2). Consequently, the risk of a full-blown equity bubble formation in the US cannot be ruled out. If this occurs, all EM risk assets will rally along with the S&P 500. US policymakers are throwing everything into the system to keep financial asset prices inflated. It seems that after any day that the S&P 500 sells off, the Fed or the US administration comes up with some sort of new measure to support the economy and asset prices. Historically, investors have placed a lot of weight on the Fed’s actions. Aggressive measures by the Fed have recently led investors to purchase stocks and corporate bonds, irrespective of the condition of the underlying economy. As a result, share prices worldwide have decoupled from corporate profit expectations (Chart I-3A and I-3B). If US policymakers succeed in lifting US share prices further, every investor will likely chase the rally and the US equity market will become a full-scale bubble. Chart I-3AGlobal Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Global Stocks Are Pricing In A Lot Of Good News Chart I-3BSurging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Surging EM Share Prices Amid Plunging Forward EPS Chart I-4Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes Retail Investors Have Driven Up Trading Volumes At some point, the bubble will start cracking even if corporate earnings find their way back to a recovery path. When equities make up a large share of investors’ assets, any trigger could lead to marginal sellers outnumbering marginal buyers. As we discuss below, there are plenty of risks that could result in a trigger. Both retail and institutional investors are very averse to losses, and when the market begins to slide, investors will sell their shares simultaneously. The market will plunge. The Fed will be forced to buy stocks to avert the negative impact of falling share prices on the economy. In a nutshell, US equities and corporate bonds have become extremely dependent on the Fed. This might be good news in the short and medium term. Nevertheless, it is negative for the US in the long run. Second, when retail investors rush into the market and actively trade, fundamentals take the back seat. This is what has been occurring since March. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks. This is illustrated by the surge in turnover volumes on the Nasdaq as well as in Southwest Airline, Norwegian Cruise Lines and Chesapeake Energy stocks (Chart I-4). Yet the impact of their actions is not limited to these stocks. Stocks are fungible. When retail investors purchase shares of near-bankrupt companies at elevated prices (at higher than fundamentals warrant), institutional investors sell those stocks and move capital to other companies. In aggregate, the stock market index rises.  The ongoing retail investor mania is not solely a US phenomenon. It has become prevalent in many other countries. There are anecdotes that Japanese retail investors have been actively trading Jasdaq stocks, while Korean, Taiwanese and Filipino retail investors have been buying local shares en masse.1  The top panel of Chart I-5 illustrates that Korean individual investors have been accumulating stocks while foreigners have been selling out. In Taiwan, the share of individual investors in equity trading has been rising at the expense of domestic institutional investors (Chart I-5, bottom panel). Retail investors do not do much fundamental analysis, and it should not come as a surprise that share prices have decoupled from their fundamentals (profits) and have gained despite lingering massive risks. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks.  Third, the mania phase – the last and most speculative stage – in bubble formation typically lasts between nine and 18 months. This is based on the duration of the mania phase in the Nikkei (1989), the NASDAQ (1999-2000), oil (2008) and Chinese A shares (2014-‘15) (Chart I-6). The retail investor-driven equity mania began in March and is now three months old. If the duration of previous manias is any guide, the current rally could last another six months at least. Chart I-5Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Strong Retail Buying Is Also Evident In Korea And Taiwan Chart I-6How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? How Long Mania Phase Lasted During Previous Bubbles? Chart I-7China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS China A-Share Bubble: A Divergence Between Stocks And EPS The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. Chart I-7 demonstrates that Chinese A-share prices skyrocketed in H1 2015, despite a deteriorating corporate profit picture. It lasted for a while and ended with a bust without any policy tightening taking place. Finally, retail investors are not quick to give up when they lose money. Having acquired a taste for capital gains over the past few months, retail investors will likely become even more aggressive and will keep buying the dips. In such a scenario, institutional and professional investors may be forced to capitulate and chase risk assets higher. We are at a fork in the road: either retail investors will begin reducing their equity holdings soon, or institutional and professional investors will capitulate and start buying en masse. In the first scenario, stocks will tumble as retail investors rapidly head for the exits. The latter scenario on the other hand will push share prices considerably higher. This is the basis behind our strategy of chasing momentum from this point on. Bottom Line: All financial market manias eventually crash. However, if the market breaks out, the rally could endure for several months. Not chasing the rally will be very painful for portfolio managers. This is why even though we believe the current global equity rally has been a FOMO-driven mania, we recommend to play it if EM share prices break above, and the broad-trade weighted dollar relapses below, current levels. Plenty Of (Disregarded) Risks Chart I-8Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Number Of New Inflections Is Rising In Large EM Countries Even though global risk assets have been rallying, the global investment landscape remains poor, with plenty of risks. In particular: Geopolitical tensions are bound to rise between the US and China. Taiwan and its semiconductor sector are at the epicenter of the US-China technological and geopolitical standoffs. Timing any escalation is tricky, but Taiwanese stocks are not pricing in these risks. Further, odds are high that North Korea will test a strategic weapon, which will undermine the credibility of President Trump’s foreign policy. This is negative for the KOSPI and the Korean won. An escalation in US-China tensions encompassing technology, Hong Kong, Taiwan and the Koreas is negative for equity markets in China, South Korea and Taiwan alike. Together they account for about 60% of the EM MSCI equity benchmark market cap. Moreover, the China-India skirmish is a risk for Indian stocks. The number of new Covid-19 infections is rising in the majority of EM countries excluding China, Korea and Taiwan as demonstrated in Chart I-8. It will be hard to ameliorate consumer and business confidence and thereby boost spending in these countries amid a worsening trend in the global pandemic. Indeed, a second wave of the coronavirus now hitting Beijing is evidence that even the very efficient Chinese system is not able to prevent pockets of renewed infection outbreaks. This risk still looms large over many advanced and developing nations after the first wave subsides. The post-lockdown natural snapback in economic activity is creating a mirage of a V-shaped recovery. Like any mirage, it can last and drive markets for a while. However, it will eventually fade. When that happens, misalignments in financial markets will be ironed out rather abruptly. A snapback in economic activity around the world is natural following the unwinding of strict lockdowns. Nevertheless, the level of business activity remains very low. Going forward, persistent social distancing, the threat of a second wave and an initial substantial income drawdown will cap the speed of recovery in household and business spending around the world. In our February 20 report titled EM: Growing Risk Of A Breakdown, we contended that the most likely trajectory for Chinese growth is the one demonstrated in Chart I-9. It assumed the plunge in business activity would be succeeded by a rather sharp snap-back due to pent-up demand. However, this snapback would likely be followed by weaker growth in the following months. This is also our roadmap for the business cycles of many DM and EM economies. Even though on May 28 we upgraded our economic outlook for Chinese growth from negative to mildly positive, near-term risks for China-related plays remain. Consistent with the trajectory described above, the Chinese economy has been coming back to life, aided in large part by significant credit and fiscal stimulus (Chart I-10, top and middle panel). Traditional infrastructure investment has accelerated strongly (Chart I-10, bottom panel). Chart I-9Our Roadmap For China’s Business Cycle EM: Follow The Momentum EM: Follow The Momentum Chart I-10China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating China: Money/Credit And Infrastructure Are Accelerating   Consequently, mainland demand for commodities has been very robust and raw materials prices have rallied. However, it remains to be seen if the recent strength in commodities purchases can be maintained going forward. A couple of our indicators and market price signals are also suggesting that caution is warranted in the near term with respect to China-related plays. First, our indicators for marginal propensity to spend among households and enterprises continue to deteriorate, even when May data points are included (Chart I-11). These indicators have been good pointers for consumer discretionary spending and business investment/demand for industrial metals, as illustrated in Chart I-11. Chart I-11Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Marginal Propensity To Spend Is Falling For Consumers And Enterprises Chart I-12Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices Copper: Shanghai/London Premium And Prices   Second, the copper price premium in Shanghai over London has been a good coincident indicator for copper prices and has recently been flagging short-term risks to copper prices (Chart I-12). A rising Shanghai/London copper premium implies more robust demand in China, while a declining premium signals weaker copper demand in the mainland. Finally, share prices of property developers, industrials and materials in the onshore market have failed to advance much (Chart I-13). This fact does not corroborate that there is a strong recovery occurring in China’s broad capital spending outside infrastructure. Chart I-13Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery Chinese Stocks Do Not Corroborate A Strong Recovery A similar message stems from the investable universe of Chinese stocks. We are using the sector indexes from the onshore market because they are less hyped by the global FOMO rally, and the number of companies included in these onshore sector indexes is larger than in the investable indexes. Bank share prices have done even worse (Chart I-13, bottom panel). Overall, near-term risks to China-plays remain and we are looking for a better entry point in the weeks and months ahead. The trend-setting US equity market is expensive, as we corroborated in our report on EM and US equity valuations a month ago. The forward P/E ratio stands at 22, using analysts’ 12-month forward EPS expectations that we believe are still optimistic. Global financial market correlations are presently high, and domestic conditions in EM ex-China, Korea and Taiwan are rather grim. If the S&P 500 relapses for whatever reason, there is little chance EM risk assets will avoid selling off. Bottom Line: Risks are abundant and fundamentals (profits, valuations, geopolitical risks, the ongoing pandemic) do not justify higher share prices. However, if a FOMO-driven rush into stocks persists, financial markets will continue ignoring fundamentals. Investment Strategy: Momentum Is Now King When retail investors invest aggressively and central banks buy assets en masse, it is not the time for fundamental analysis. Indeed, momentum becomes king. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. Our composite momentum indicator for global share prices has risen to zero from extremely oversold levels (Chart I-14). Chart I-14Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture Global Share Prices Are At A Critical Juncture If global and EM share prices break meaningfully above their 200-day moving averages and the US dollar breaks materially below its 200-day moving average (see Chart I-1 on page 1), our advice will be for investors to chase the rally. Even if DM and EM share prices break out, the odds are that EM stocks will continue underperforming DM ones. Hence, we continue to underweight EM in a global equity portfolio. The basis is that North Asian equity markets (China, Korea and Taiwan) are at risk of a heightened geopolitical confrontation between the US and China, as per our discussion above. Meanwhile, the remainder of EM is struggling with the pandemic. Hence, EM will continue to underperform, even if global share prices rise a lot. The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. That said, if global stocks and commodities prices break out and the greenback breaks down, we will close our remaining short positions in EM currencies and upgrade our stance on EM fixed-income markets from neutral to bullish. We have been receiving rates in Mexico, Colombia, Russia, India, China, Korea, Pakistan, Ukraine and Egypt, but have been reluctant to take on currency risk. Also, we upgraded our stance on EM credit markets to neutral on June 4. We will likely upgrade EM local currency bonds and EM credit markets further to “buy” if the above-mentioned breakouts transpire. Upgrade Chinese, Downgrade Korean Stocks Chart I-15DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks DRAM And Korean Tech Stocks We are moving China from neutral to overweight and downgrading Korea from overweight to neutral relative to the EM equity benchmark. Regarding Korean equities, the risks are as follows: First, rising threats of North Korea testing a strategic weapon is negative for South Korea’s equities and currency. Second, DRAM prices and volumes are dropping. Chart I-15 shows that the DRAM revenue proxy is falling, a bad omen for Korean tech stocks that derive a lot of operating profits from DRAM sales.  Finally, the Korean bourse is heavy in old-economy stocks, which will experience a slow recovery in their profits from very low levels amid the enduring global trade downturn.  The reasons to upgrade Chinese investable stocks relative to the EM equity benchmark include: As we discussed above, the medium-term growth outlook for China is mildly positive due to the credit and fiscal stimulus Beijing has unleashed. The outlook for domestic demand is worse in many other developing economies. The credit and money bubble in China will inflate further and will pose a major challenge in the years ahead. That said, another round of major credit/money expansion will likely stabilize the system in the medium term. If the FOMO-driven mania continues, FAANG stocks will likely outperform, which will spread to similar stocks around the world. The Chinese investable index includes Alibaba, Tencent and other new economy stocks that will likely outperform the EM benchmark. If global markets correct and EM currencies drop, the Chinese RMB will appreciate relative to most EM exchange rates. This will help China’s equity performance relative to other EM bourses. Finally, if US-China tensions escalate and EM markets sell off, Chinese authorities will support share prices by deploying the national team and other government proxies to buy Chinese stocks. This will help the broad universe of Chinese stocks to outperform the EM benchmark. Chart I-16Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Long Chinese Investable / Short Korean Equities Bottom Line: We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Market-neutral investors should consider the following trade: long Chinese / short Korean equities (Chart I-16).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   1     Please see the following articles: Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations