Euro Area

Highlights COVID-19 In Europe: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. ECB: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. European Bond Strategy: Stay overweight core European government debt, particularly versus US Treasuries. Remain overweight Italian and Spanish government bonds, as well, which remain supported by both ECB asset purchases and perceptions of increases European fiscal integration. Stay cautious on euro area corporate debt, however, as the renewed recession risk comes at a time when yields and spreads offer poor protection from future credit downgrades and defaults. Feature Chart of the WeekA Bad Time For A Second Wave A Bad Time For A Second Wave A Bad Time For A Second Wave Today’s long anticipated US election will be the focus for investors in the coming days (and, potentially, weeks) as all votes are counted. We have discussed our views on the potential bond market impact of the election - bearish for US Treasuries with both Joe Biden and Donald Trump promising big fiscal stimulus in 2021 – in our previous two reports. We will provide an update of those views as soon as we get clarity on the election result. This week, we discuss a new concern for jittery markets - the explosion of new COVID-19 cases in Europe that has already led to governments imposing aggressive lockdown measures. The timing of the new viral surge could not be worse for the euro area economy, which had recovered smartly from the massive lockdown-related demand shock this past spring. Real GDP for the entire euro area exploded higher at a 12.7% rate in Q3/2020, a big rebound from the 11.8% drop in Q2. Yet the second wave of coronavirus is starting to weigh on the more domestically focused service sectors most vulnerable to lockdowns and declining consumer confidence (Chart of the Week). From the perspective of European fixed income strategy, the imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. This will support the performance of euro area government bond markets, both in absolute terms and especially versus US Treasuries where yields are drifting higher and should continue to do so after the US election. Another Deflationary Shock To Europe From The Virus The surge in COVID-19 cases has hit the euro area hard and fast. France has seen the most stunning increase, with a population-adjusted daily increase of 596 new cases per million, a nearly six-fold increase in just two months (Chart 2). Importantly, this second wave has so far been nowhere near as lethal as the first wave. The “case fatality ratio” – confirmed deaths as a percentage of confirmed cases – is down in the low single digits for the largest euro area countries (bottom panel). The imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. Even with this second wave being less deadly, governments are taking no chances. France and Germany announced national lockdowns last week for at least the month of November, and Italy and Spain have put new restrictions on activity as well. The new lockdowns are already denting consumer confidence across the euro area and this trend will continue as people choose to spend less time outside of their homes to avoid infection. If the case numbers do not begin to stabilize and the lockdown measures extend into December or beyond, governments will likely be forced to consider new fiscal stimulus measures. According to the latest IMF Fiscal Monitor, the largest euro area economies are projected to have a negative “fiscal thrust” – the change in the cyclically-adjusted primary budget balance as a share of potential GDP – in 2021 of at least -3% of GDP (Chart 3). Chart 22nd Wave Of European Coronavirus Is Far Less Lethal 2nd Wave Of European Coronavirus Is Far Less Lethal 2nd Wave Of European Coronavirus Is Far Less Lethal Chart 3A Big European Fiscal Drag Coming Next Year The Implications Of Europe's Second Wave Of Coronavirus The Implications Of Europe's Second Wave Of Coronavirus In the case of Italy, the fiscal thrust is expected to be a whopping -6.6% of GDP. The main cause is reduced government spending as the massive temporary stimulus measures to fight the 2020 COVID-19 recessions roll off. Chart 4The ECB Has A Deflation Problem The ECB Has A Deflation Problem The ECB Has A Deflation Problem A fresh set of lockdowns will result in a need for more government support measures for unemployed workers, especially those in service-related industries like hospitality and tourism most exposed to lost business as consumers stay home. This poses a serious problem in countries like Spain and Italy that saw a rise in unemployment during the first lockdown but have seen no reversal since (Chart 4). More elevated unemployment rates suggest a lack of inflationary pressure, a point confirmed by recent inflation data. Overall headline HICP inflation fell to -0.3% in September, while core inflation is now a mere +0.4%. Headline HICP inflation rates are now below 0% in the largest euro area economies (Germany, France, Italy and Spain), while core HICP inflation in Italy fell to -0.3% in September. The collapse in oil prices earlier in 2020 has been the main cause of the negative headline inflation prints in the euro area, but is not the only source of weak inflation. According to a decomposition of inflation presented in the Bank of Italy’s October 2020 Economic Bulletin, a falling contribution from services inflation was responsible for about one-third of the entire decline in euro area headline HICP inflation since January (Chart 5). This comes from the part of the euro area economy most exposed to COVID-19 restrictions, highlighting the deflationary risk of the second wave. Chart 5Euro Area Deflation Is Mostly, But Not Only, Driven By Oil The Implications Of Europe's Second Wave Of Coronavirus The Implications Of Europe's Second Wave Of Coronavirus Simply put, the second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Policymakers need to spring into action to help provide support for the euro area economy during this time, starting with the ECB. The second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Bottom Line: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. The ECB Will Deliver New Stimulus In December At last week’s policy meeting, ECB President Christine Lagarde announced that the Governing Council would reassess its monetary policy stance at the December meeting, when a new set of economic projections would be presented that factored in the negative impact of the second COVID-19 wave. Lagarde was very candid about the expected outcome of that next meeting, when she stated that the ECB would “recalibrate its instruments” based on the new economic forecasts. Chart 6European Banks Are Tigthening Lending Standards European Banks Are Tigthening Lending Standards European Banks Are Tigthening Lending Standards In our view, the ECB’s next policy options can only realistically focus on three options: Cutting policy rates deeper into negative territory Increasing the size, or altering the composition of its bond-buying programs Altering the terms of its current Targeted Long-Term Refinancing Operations (TLTROs) We view a rate cut as a low probability outcome. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. According to the ECB’s latest Bank Lending Survey, euro area banks tightened credit conditions in Q3/2020 (Chart 6). Worsening perceptions of risk and a deteriorating economic outlook were cited as the main reasons for tightening lending standards. The tightening was most severe in Spain, but Italy also saw a big swing away from the easing standards seen in the Q2/2020 survey. Within the details of the Q3/2020 survey, the demand for loans from companies was expected to improve in Q4/2020. The demand for housing and consumer credit increased due to favorable borrowing conditions and a softening in negative contribution from consumer sentiment. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. The ECB’s bond buying programs – the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP) – were deemed to have a positive impact on bank liquidity and financing but a negative impact on profitability. Chart 7Low Interest Rates Are Crushing European Bank Stocks Low Interest Rates Are Crushing European Bank Stocks Low Interest Rates Are Crushing European Bank Stocks Therein lies the problem of the ECB’s negative interest rate policy and large-scale bond buying – it has lowered borrowing costs for euro area governments, consumers and businesses, but has crushed the profits of Europe’s banks. That can be seen when looking at the ongoing miserable performance of euro area bank stocks, which continue to plumb new lows. The relative performance of euro area banks versus the broad equity market benchmark index tracks the slope of government bond yield curves quite closely in the major euro area economies (Chart 7), highlighting the link between the level of euro area interest rates and bank profits. In Chart 8A, we show the Tier 1 capital ratio, as well as the non-performing loan (NPL) ratio for the five largest banks in Germany, France, Italy, Spain and the Netherlands. The message from the chart is clear – European banks remain well capitalized, with double-digit Tier 1 capital ratios well in excess of regulatory minimums, and have a relatively low share of assets that are non-performing. This is especially true in Italy, where the NPL ratio has collapsed from a high of 20% to 7% over the past five years. In Chart 8B, we present the return on equity and return on asset ratios for the same banks presented in the previous chart. Most large euro area banks suffer from a very low return on assets, not materially above 0%, reflecting the non-existent interest rates banks earn on their government bond holdings as well as the low rates on their loan books. Chart 8AEuropean Banks: The Good News European Banks: The Good News European Banks: The Good News Chart 8BEuropean Banks: The Bad News European Banks: The Bad News European Banks: The Bad News So given the fragile state of euro area bank health, and with banks already tightening lending standards in anticipation of slower economic activity because of second wave lockdowns, we can rule out a policy interest rate cut as an option to ease policy in December. This leaves only two other easing options, both associated with an expansion of the ECB’s balance sheet – more asset purchases of sovereign bonds and encouraging bank lending through cheap funding via TLTROs (Chart 9). The impact of either policy in offsetting slowing growth is debatable. Government bond yields are already miniscule, if not outright negative, across the euro area and do not represent a hindrance to increased government spending. The ECB can tweak some of the terms of the existing TLTRO programs, like maturity or the price of funding, but that may not encourage new lending if both borrowers and lenders fear a double-dip recession because of the second wave. The pressure is on the ECB to do something to stem the decline in euro area inflation. Nonetheless, the pressure is on the ECB to do something to stem the decline in euro area inflation. While real interest rates are still negative, they are increasingly becoming less so as inflation expectations continue to drift lower. The 5-year/5-year forward EUR CPI swap rate is now down to 1.1%, and was last trading near the ECB’s inflation target of just under 2% in 2013-14 (Chart 10). Unsurprisingly, the rising real rate backdrop has helped boost the value of the euro, especially versus the US dollar, which has suffered under the weight of falling real US interest rates this year. Chart 9The ECB Can Only Expand Its Balance Sheet The ECB Can Only Expand Its Balance Sheet The ECB Can Only Expand Its Balance Sheet In the end, greater fiscal stimulus will be the only option available to get Europe through the second wave. All the ECB can do is provide a backdrop of loose monetary policy that supports easy financial conditions, so that any stimulus will have the maximum effect on growth. Chart 10Deflation Is Pushing Up Real Rates In Europe Deflation Is Pushing Up Real Rates In Europe Deflation Is Pushing Up Real Rates In Europe Bottom Line: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. Stay Overweight European Government Bonds, But Stay Cautious On Euro Area Credit With the ECB set to deliver some form of easing in December, core European bond yields are likely to remain stable over at least the next six months. The ECB has shown no reservations about expanding its balance sheet via bond purchases when needed. A surge of buying similar in size to that of the first COVID-19 wave is not out of the question if Europe faces a double-dip second wave recession (Chart 11). Chart 11Stay Overweight Core European Government Bonds Stay Overweight Core European Government Bonds Stay Overweight Core European Government Bonds Chart 12Italian BTPs Are Preferable To Euro Area Corporate Credit Italian BTPs Are Preferable To Euro Area Corporate Credit Italian BTPs Are Preferable To Euro Area Corporate Credit In an environment where we see US Treasury yields having more upside on the back of post-election fiscal stimulus, this makes the likes of German bunds and French OATs good “defensive” lower-beta plays to replace high-beta US Treasury exposure in global USD-hedged bond portfolios. We also like core Europe as a pure spread trade versus Treasuries, as we see scope for the UST-Bund spread to widen further – a tactical trade we initiated last week (see our Tactical Overlay table on page 15). We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying.  We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying (Chart 12). The ECB has already been purchasing a greater share of Italy in the PEPP, allowing significant deviations from the Capital Key weights that limit purchases in the older APP. ECB President Lagarde noted last week that those deviations will continue over the life of the PEPP, which should help support further declines in Italian bond yields over at least the next six months. We are maintaining a relatively cautious stance on European credit, however, even with the ECB likely to make a move in December. The renewed recession risk from the second wave comes at a time when low yields and spreads for euro area corporate bonds offer poor protection from future credit downgrades and defaults. We continue to prefer owning US corporate credit, both investment grade and high-yield, versus US equivalents in USD-hedged bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Implications Of Europe's Second Wave Of Coronavirus The Implications Of Europe's Second Wave Of Coronavirus Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics.   Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long.   Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. World: Basic Resources Vs. Financials World: Basic Resources Vs. Financials   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights The great political surprises of 2016 are approaching key deadlines on November 3 and December 31. Investors should not let Brexit take their eye off the US election. Globalization will retreat faster under Trump regardless of what happens in the United Kingdom. The market is starting to price several clear risks: a failure to extend fiscal relief in the US (25% chance); a surprise Trump tariff move (40%); a contested election (20%); or a failure of the UK and EU to seal a deal (35%). Trump is unlikely to pull off a landslide like Boris Johnson in December 2019. The backdrop has darkened and Biden is an acceptable alternative for voters, unlike Jeremy Corbyn. Go long GBP-USD at the 1.25 mark; go long GBP-EUR volatility. Feature The end game is approaching for the two great political shocks of 2016 – Brexit and Trump. November 3 is the US election and December 31 is the deadline for an UK-EU trade deal. Investor sentiment is starting to show some cracks for various reasons, some technical (Chart 1). But we do not believe near-term volatility and risk-off sentiment have fully run their course yet. Either the US election cycle or the UK’s brinkmanship with the EU, or both, will agitate markets as the deadlines approach. The former is a much weightier factor. Chart 1Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive The risks in play are a failure to extend fiscal relief in the US (25% chance); a conflict between Trump and one of America’s foreign rivals such as China, whether due to Trump’s reelection or lame duck status (40%); a contested election (20%); or a failure of the UK and EU to seal a deal, setting back their economic recovery (35%). Maybe all of these risks will dissipate by mid-November, but maybe not. The market has not discounted any of them fully. So investors should buy insurance now. Vox Populi Is The Biggest Constraint For global investors Brexit is far less consequential than President Trump’s “America First” policy but the UK does punch above its economic weight in financial markets (Chart 2). Chart 2Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Geopolitical analysis teaches that limitations on policymakers should be the starting point of analysis. For democracies, the biggest constraint of all is the vox populi – the voice of the people, or popular will. The Brexit movement faced a vociferous “Resistance” that won over the media and financial market consensus until reality struck in the general election of December 12, in which the Conservative Party won a historic victory. Chart 3Joe Biden Is Not Jeremy Corbyn The End-Game For Trump And Brexit The End-Game For Trump And Brexit The election vindicated Prime Minister Boris Johnson’s brinkmanship and “hard Brexit” terms, while once again chastening the elites and experts – including an innovative Supreme Court. Johnson’s single-party majority, combined with COVID-19 and the surge in domestic economic stimulus, have increased the odds that the UK will choose sovereignty over the economy and walk away from trade talks. Trump’s supporters show the same enthusiasm as Brexiteers and the same scorn for conventional wisdom and opinion polls. Will they be similarly vindicated? Beyond any knee-jerk equity rally, that would entail a “Phase Two” trade war with China – and possibly a new trade war with Europe or a global trade war. However, Trump faces much worse odds than Boris Johnson did. First, Johnson’s snap election took place at the top of the business cycle, back when a novel coronavirus was just starting to be discovered in Wuhan, China. This is how Harry Truman won his surprise victory in 1948, in defiance of all the opinion polls. Had Truman run in 1949, after a deep recession, the story would have gone differently – which is a problem for both Trump and the near-term equity market. Second, the political alternative was not acceptable in the United Kingdom but it is in the United States. Johnson led Jeremy Corbyn, a far-left rival for the premiership, by around 15%-20% in the polls. The Conservative Party itself led the Labour Party by 10%. By contrast, former Vice President Joe Biden is a center-left Democrat who has many flaws but is not out of the mainstream. He leads President Trump in the polling, as do Democrats over Republicans, though only by single digits. There is no contest between Biden and Corbyn (Chart 3). Trump might still win, but an American version of the UK landslide in 2019 is unlikely. Trump will lose the popular vote even if he wins the Electoral College, and Republicans have a very slim chance of winning the House of Representatives. The implication for financial markets is doubly negative, at least in the near term: there is about a 35% chance that the UK will leave without a deal and about a 35% chance that Trump will win. He could also kick China in the interim period if he loses. Won’t stocks cheer a Trump comeback and victory? Perhaps, but a data-dependent approach suggests that a “blue sweep” is still the base case, and that would be a good trigger for a full equity correction. Nor would a Trump win be positive for long-term equity returns in the final analysis. Trump is reflationary, but a larger trade war would hamper the global economic recovery and thus keep earnings suppressed. There is a 35% chance that Trump will win re-election. Trump is unlikely to win the national vox populi, like Brexit did, but he obviously can win the popular vote in the critical regions – the Sun Belt and the Rust Belt. If he does, the revolution in the global system will be confirmed: the retreat of globalization will accelerate. If he does not, then Brexit alone cannot confirm de-globalization; rather the UK will face even more pressure to make concessions and get a trade deal. Trump’s Path To Victory Chart 4Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 We may well be forced to upgrade Trump’s odds of winning if his comeback gains momentum. Our subjective odds of a Trump win come from the historical record – incumbent parties only retain the White House amid recessions five out of 13 times in American history – but there are some important exceptions. First, the longest-serving American president, Franklin Delano Roosevelt, served during the Great Depression. So obviously a bad economy does not always disqualify a president. Nevertheless FDR got lucky with the timing of the fluctuations and he was personally popular, unlike President Trump. Second, an incumbent president wins 50% of the time if the recession ends before the election – namely in 1900, 1904, and 1924 (contrasted with defeats in 1888, 1912, and 1980). Today’s market performance looks similar to these cases, though premature fiscal tightening is now jeopardizing Trump’s bid (Chart 4). Assuming new stimulus passes, it is extremely beneficial for President Trump that COVID-19 cases are subsiding (Chart 5). Chart 5COVID-19 Subsides In Nick Of Time For Trump? The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 6Even Approval Of Trump’s Pandemic Response Improving The End-Game For Trump And Brexit The End-Game For Trump And Brexit His approval rating on handling COVID-19 is somewhat recovering at the moment (Chart 6). Trump’s “law and order” message is also benefiting him amid the rise in vandalism, rioting, and homicide, judging by his improvement in national approval rating across almost all demographic groups, including many that are otherwise averse to Trump. Finally, Trump’s Abraham Accords – a potentially major peace deal between Israel and an expanding list of Arab states – could give his image another boost (Table 1). Foreign policy will not decide the election but these peace deals should not be underrated because they underscore a more important argument for voters: that the US should withdraw from its endless foreign wars and pursue peace and prosperity instead. If Trump’s typically weak approval rating on foreign policy starts to rise then his comeback gains breadth. Table 1The Abraham Accords Give Boost To Trump Image As Peacemaker The End-Game For Trump And Brexit The End-Game For Trump And Brexit We will upgrade our 35% odds of Trump’s re-election if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Our quantitative model is now giving Trump a 45% chance, which is in line with the consensus view but well above our subjective odds (Chart 7). We will upgrade our view if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Chart 7Quantitative US Election Model Puts Trump Win At 45% Odds The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 8Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell The stock market does not perform well during periods in which fiscal cliff negotiations are prolonged – the failure of the Emergency Economic Stabilization Act in 2008 is one thing, but today’s impasse is more reminiscent of the debt ceiling crises of 2011 and 2013. Trump is now directly pressuring Senate Republicans to capitulate to House Democratic spending demands. If Republican senators abandon him, market turmoil will undercut his argument that he is the best man to revive the economy and he will lose the election (Chart 8). We do not think they will – and House Speaker Nancy Pelosi’s pledge to keep the House in session until a deal is passed is very positive news – but until the deal is sealed the market is vulnerable. As mentioned above we give a 25% chance of a failure to pass any stimulus bill in September or October. The next chance for stimulus will be in late January or February. Trump stands for growth at all costs, which will be received well by equity markets, other things being equal. But a Trump victory implies more trade war and that the GOP will retain the Senate, creating a steeper fiscal cliff next year – so any relief rally will be short-lived. Meanwhile a Trump defeat raises the risk he will take aggressive actions on the way out to cement his legacy as the Man Who Confronted China, and bind the Biden administration to decoupling policy. This is not a favorable outlook for investor sentiment or the economic recovery over the next few months. Brexit: The Three Kingdoms Will Force A Trade Deal Chart 9Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal In December 2016 we pointed to the three kingdoms – England, Ireland, and Scotland – as the origin of the geopolitical and constitutional crisis that would arise from the Brexit referendum and act as a powerful bar against a no-deal Brexit. That framework remains salient today as the risk of no-deal escalates due to quarrels over Northern Ireland Protocol, which was agreed in October 2019 as part of the formal Withdrawal Agreement that made Brexit happen on January 31, 2020. The implication is that the pound has not bottomed yet, though we see a buying opportunity around the corner (Chart 9). No one should doubt that the UK could walk away from the EU without a deal this December: The Tories’ single-party majority gives them the raw capability to push through plans they decide on – and raises the risk that they will overreach. The tariff shock of a no-deal exit is frequently exaggerated. The UK would suffer a tariff shock of about 1.38% of GDP, larger than what the US suffered in its tariff-war with China but hardly a death knell (Table 2). (The costs of losing single-market access would grow over time, however.) Table 2A No-Trade-Deal Brexit Would Create A Minimum Tariff Shock Of 1.4% Of GDP The End-Game For Trump And Brexit The End-Game For Trump And Brexit COVID-19 has supplanted the worst-case outcome of a no-deal exit by producing a much worse recession than anyone feared. The US is using the disruption to decouple from China and the UK could do the same with the EU. The result of COVID-19 is massive domestic stimulus that raises the UK’s and Europe’s threshold for pain. Any failure of trade talks would spur more stimulus. The Bank of England still has some bond-buying ammunition left and parliament, again, is undivided. Given that Boris Johnson has until 2024 before the next election, there is theoretically time for his personal and party approval ratings to improve as the economy recovers from the pandemic and any messy Brexit (Chart 10). Chart 10Bojo Has Until 2024 To Recover From Crises The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 11UK Would Face WTO-Level Tariffs If No Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit The UK’s position in the quarrel over Ireland is rational – but so is the EU’s. If the trade talks collapse, the UK will need to remove any regulatory or customs divisions with Northern Ireland. Yet in preparing to do so it vitiates trust with the EU and makes a trade deal less likely. However, weighing all these points up, an UK-EU trade deal is still the most likely outcome (65% chance), as the economic and political costs are crystal clear while the benefits of a hard break are not so clear. Allow us to explain. Northern Ireland is the latest cause of tensions, although it was inevitable that tensions would arise ahead of the end-of-year deadline for a trade deal. Westminster has proposed an Internal Market Bill, which has passed with solid majorities in two readings in parliament, to reclaim aspects of sovereignty over Northern Ireland that were traded away to clinch the Withdrawal Agreement last year. The Johnson government’s position should be seen as a negotiating tactic to build leverage in the talks but also as a real fallback position if the talks fail. The House of Lords could delay the bill by a year, meaning that it may not take effect until end of 2021 – but a trade deal would make it moot. The Northern Ireland Protocol solved the riddle of how to preserve the integrity of the EU’s single market after Brexit yet avoid a return to a hard customs border with the Republic of Ireland. Customs checks were removed with the Good Friday (or Belfast) Agreement in 1998, which ended the Troubles between the two Irelands. The Protocol introduces a pseudo-customs border on the Irish Sea, requiring declarations on exports to Great Britain and EU oversight of UK state aid for Northern Irish firms, so that Northern Ireland can stay in the EU customs area while the UK can leave and still preserve a semblance of its own customs area in Northern Ireland. If the UK and EU get a trade deal, then all trade is tariff-free and the Protocol becomes redundant. Also, the Protocol enables a Joint Committee to review disputes over exports to Northern Ireland that are “at risk” of making their way into the EU without duties. The Protocol is supposed to operate even if the UK and EU fail to get a trade deal. Yet it is politically untenable for the UK to subject trade within its own country to EU rules or duties, or allow the EU to supervise state corporate subsidies across the UK, if no deal is agreed. The UK is more likely to violate the treaty to preserve its internal integrity. As Northern Ireland Secretary Brandon Lewis admitted, “Yes, this [Internal Market Bill] does break international law in a very specific and limited way.” While the EU’s threat to slap tariffs on British food exports to Northern Ireland is the proximate trigger of the Internal Market Bill, another key reason for the UK’s aggressive shift is the issue of state aid. All governments are extending emergency aid to major corporations to keep them from insolvency amid the recession. This will be the case for some time and it is even more true of the EU than of the United Kingdom. However, under the Protocol, the EU would be able to penalize companies in Great Britain that receive subsidies if goods or firms in Northern Ireland can be shown to benefit. Northern Ireland is supposed to operate within the EU’s standards on state aid. London obviously bristles at this backdoor for letting in EU regulation, not least because, in the event that a trade deal is not reached, it will need to pump the country full of state aid to compensate for the shock of seeing exports to the EU rise by 3% across the board according to Most Favored Nation status under the World Trade Organization (Chart 11). An UK-EU trade deal is the most likely outcome. As Dhaval Joshi of BCA’s European Investment Strategy points out, Boris needs to keep his own Tories under his heel (Chart 12). The Internal Market Bill provoked a backlash among 30 moderates. If that number rises to 40 Johnson loses his majority. This is a problem that he is seeking to address by giving parliament a veto over any future uses of the bill that would violate international law (this is an acceptable compromise because he has a majority). But a failure to drive a hard bargain with the EU would cause a much bigger rebellion among hard Brexit Conservative MPs and threaten his job. Chart 12Bojo Must Balance Hard Brexit Tories The End-Game For Trump And Brexit The End-Game For Trump And Brexit Geopolitics is about might, not right – the UK can assert its sovereignty and violate these international agreements, while the EU can then apply punitive tariffs, non-tariff barriers, and sanctions under the Withdrawal Agreement. Brexit is a power-political struggle that could devolve into a trade war. Obviously that would be a very bad outcome for the market, particularly for the UK, which is overmatched (Chart 13). But this risk is also a key limitation on the UK that will prevent this worst-case outcome. Indeed, despite all of the above, our base case is still that the UK and EU will get a deal. First, the economy will clearly suffer without a deal. After all, the US-China tariffs produced a negative effect for these two economies in 2019 and the impact on the UK would be bigger than that on the US (Chart 14). Chart 13The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid Chart 14UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal Second, the public doesn’t support a no-deal exit (Chart 15). Northern Ireland itself voted against Brexit in the referendum and as such would rather see an agreement that groups the UK and the EU under a single zero-tariff free trade agreement. Third, Boris faces a rebellion in Scotland if he pursues a hard break. The Scottish National Party would revive ahead of Scottish elections in May 2021 and demand a second independence referendum (Chart 16). The Irish Sea is a natural division that makes a more intrusive customs presence more supportable than otherwise. A little more paperwork is an acceptable cost to keep the United Kingdom from falling apart. Scotland is much more likely to go independent than Ireland is to unite. Chart 15Only 25% Think 'No Deal' A Good Outcome The End-Game For Trump And Brexit The End-Game For Trump And Brexit Boris is now prime minister, not just party leader, and he will ultimately have to decide whether he wants to be the last prime minister of a United Kingdom. Assuming Boris is at least focused on the next election, he will have to decide if he wants the rest of his premiership to be consumed with a self-inflicted double-dip recession and democratic revolt in Scotland, or a recovery on the back of a functional if uninspiring trade deal enabling him to head off the Scottish threat and save the union. Chart 16No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement Obviously the final deal may not be clinched until the eleventh hour. The October 15 deadline can be delayed but talks must conclude in November or December in time to be ratified by the EU member states by December 31. US Election Drives Geopolitics, But Not The Brexit Outcome One factor that will not play much of a role in the UK’s decision-making is the US election. It is true that the Johnson government would benefit from President Trump’s reelection. But the EU is a much bigger market for the UK and the UK’s best strategy is to focus on its national interest regardless of what the US does. The US election may not be decided in mid-December in time for the UK to agree to a deal that can be ratified by year’s end anyway. Moreover the UK’s best strategy is to conclude a deal with the EU first, and then pursue a deal with the United States. This is because President Trump will be inclined to sign at least an executive deal, while a congressional deal requires support from the Democrats, which is only possible if Northern Ireland is resolved without hard border checks. Because the EU makes up such a larger share of British trade, an American deal does not give the UK much leverage in negotiating with the EU, but an EU deal does give the UK greater leverage in negotiating with the US. As Diagrams 1 and 2 show, this strategic logic holds even if the UK knows the outcome of the US election ahead of time: the scenarios with the least benefit and the greatest cost would still be scenarios involving no deal with the European Union. Diagrams 1 & 2United Kingdom Wants An EU Trade Deal (Regardless Of Trump/Biden) The End-Game For Trump And Brexit The End-Game For Trump And Brexit Diagram 3 boils all of this down to a single decision tree. First, the diagram shows that the economic costs are not prohibitive and therefore the risk of a no-deal exit is substantial – we would say 35%. Second, it shows that the risks of the negotiation are skewed to the downside. Third, it highlights that the UK will settle its affairs directly with the EU and not hinge its actions on the US election cycle. Diagram 3No-Deal Brexit Cost Not Prohibitive, But Best Strategy Is To Get A Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit Clearly the best strategy and best outcome involve seeking a trade deal with the EU, and hence it is our base case. This means an opportunity to buy the pound and domestic-oriented British equities, and turn neutral on gilts, is just around the corner. Investment Takeaways The GBP-EUR is the best measure of the market’s sensitivity to Brexit risks, so it should fall in the near term and rally sharply after resolution. However, the US election complicates things. The euro’s response is fairly binary: it is one of the biggest winners if Biden wins and one of the biggest losers if Trump wins. Hence GBP-EUR volatility will rise in the coming months (Chart 17). We recommend going long 1-month implied volatility contracts for October and November. The pound sterling, by contrast, will ultimately rise regardless of US election result, since the UK will pursue a trade deal out of its own national interest. Trump is less negative for the US dollar than Biden and a comeback and victory will drive a counter-trend dollar bounce. However, in the medium term we expect the dollar to fall regardless due to debt monetization and global growth recovery. Thus we recommend going long GBP-USD on a strategic basis when political risks peak over the next two-to-three months and GBP-USD falls to around 1.25, as recommended by our Foreign Exchange Strategist Chester Ntonifor (Chart 18). Chart 17EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise Sterling bears are forgetting that the sound defeat of Corbyn ruled out a sharp left-wing turn in domestic economic policy (higher taxes), while the Tories have made a clear turn against fiscal austerity. Therefore the worst-case scenario is a failure to agree to a trade deal by the end of this year. But that is not the base case and the risk will be priced within a month or two. Chart 18Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Chart 19Yes, China Is Opening The Taps Yes, China Is Opening The Taps Yes, China Is Opening The Taps We remain tactically cautious and defensive even though the US fiscal negotiations are improving. The market is underrating too many clear and concrete risks to sentiment and the corporate earnings outlook, so the current bout of volatility can continue until there is greater clarity on US fiscal spending, the US election cycle, associated geopolitical risks, and the Brexit showdown. Book gains on long Brent trade for a return of 69.7%. We initiated this trade on March 27 in our “No Depression” report, which marked our shift to a strategic risk-on positioning. We remain bullish on oil prices and commodities on the back of global stimulus and our assessment that the OPEC 3.0 cartel will maintain discipline overall, but the next three-to-six months are crowded with downside risk. Cyclically, we see a global economic recovery deepening and broadening. China’s stimulus is surprising to the upside, as we have long written and the latest credit numbers bear this view out (Chart 19), which is critical for global reflation.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights We remain bearish on the US dollar over the next 12 months. The best vehicle to express this view continues to be the Scandinavian currencies (NOK and SEK). Precious metals remain a buy so long as the dollar faces downside. However, we remain more bullish on silver than gold. Go short the gold/silver ratio (GSR) again at 75. At the crosses, our favorite trade is short NZD against other cyclical currency pairs. These include the CAD, AUD, and SEK. Sterling is selling off as we anticipated, but our timing was offside. That said, the pound is cheap. We will go long cable if it falls below 1.25. Short EUR/GBP at current levels. The Swiss franc will continue to appreciate versus the USD, but will lag behind the euro. EUR/CHF will touch 1.15. We prefer the JPY to the CHF as a currency portfolio hedge. We argued last week that Prime Minster Shinzo Abe’s resignation does not change the yen’s outlook. Feature Our trade basket this year has been centered on a dollar-bearish theme. Since the top in the DXY index on March 19th, we have been expressing this view via various vehicles, most of which have been very profitable. Our favorites have been the Scandinavian currencies, silver, and the AUD, either at the crosses or against the US dollar. So far, these are among the best-performing trades in the G10 currency world (Chart I-1). Chart I-1A Currency Report Card Revisiting Our High-Conviction Trades Revisiting Our High-Conviction Trades Going into the final leg of 2020, the key question is which currency pairs will provide the most upside. In this report, we revisit the rationale behind our high-conviction trades. The Case For Scandinavian Currencies A review of Q2 GDP across the G10 reveals which countries have been doing relatively better during the pandemic. Norway emerges as the economy that had the best quarter-on-quarter annualized growth (Chart I-2). Swedish growth held up very well in Q1 and even the drop in Q2 still puts it well ahead of the US, the euro area, and the UK. As small, open economies which are very sensitive to global growth conditions, this is a very impressive feat for Sweden and Norway. Part of the reason for this is that over the years, the drop in their currencies, both against the US dollar and euro, has made them very competitive. Chart I-2A Currency Report Card A Currency Report Card A Currency Report Card Norway benefited from a few things during the pandemic. First, as a major oil exporter, the sharp fall in the NOK helped cushion the domestic economy against the crash in crude prices. Second, the handling of the pandemic was swift and rigorous, and this has almost completely purged the number of new infections in Norway. Third, aggressive monetary and fiscal stimulus (zero rates, quantitative easing, and the first budget deficit in 40 years) has set the economy on a recovery path. As a result, consumption is rebounding smartly and the Norges Bank expects mainland GDP to touch pre-crisis levels by 2023. Already, real retail sales have exploded higher (Chart I-3). Should global growth continue to rebound, a reversal in pessimism towards energy stocks (and value stocks in general) could see investors reprice the Norwegian stock market (and krone) sharply higher (Chart I-4). Chart I-3Norwegian Consumption Has##br##Recovered Norwegian Consumption Has Recovered Norwegian Consumption Has Recovered Chart I-4A Bounce In Oil & Gas Stocks Will Help The Krone A Bounce In Oil & Gas Stocks Will Help The Krone A Bounce In Oil & Gas Stocks Will Help The Krone In the case of Sweden, the sharp rebound in the manufacturing PMI also suggests the industrial base is recovering. This will also coincide with a solid bounce in exports, cementing Sweden’s rise in relative competitiveness and its exit from the pandemic-induced recession (Chart I-5). The Riksbank’s resource utilization indicator has stabilized, suggesting deflationary pressures are abating. Meanwhile, home prices are on the cusp of a recovery, which should help boost consumer confidence and support consumption. With our models showing the Swedish krona as undervalued by 19% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. Should global growth continue to rebound, a reversal in pessimism towards energy stocks could see investors reprice the Norwegian stock market (and krone) sharply higher. The bottom line is that both Norway and Sweden are well poised to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to be the best performers versus the USD in the coming year (Chart I-6).  Chart I-5The Swedish Economy Is On The Mend The Swedish Economy Is On The Mend The Swedish Economy Is On The Mend Chart I-6The Scandinavian Currencies Remain Cheap The Scandinavian Currencies Remain Cheap The Scandinavian Currencies Remain Cheap Stay Long Precious Metals, Especially Silver In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. This is especially the case on the back of a central bank that is trying to asymmetrically generate inflation. Gold has a long-standing relationship with negative interest rates, though the correlation has shifted over time. The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income-generating assets such as gold. But more importantly, the correlation is between the rise in gold prices and the level of real interest rates, meaning as long as the latter stays negative, it is sufficient to sustain the gold bull market (Chart I-7). Gold tends to be a “Giffen good,” meaning demand increases as prices rise. This can be seen in the tight correlation between our financial demand indicator (proxied by open futures interest on the Comex and ETF holdings, Chart I-8) and gold prices. The conclusion is that, just like the US dollar, gold tends to be a momentum asset, where higher prices beget more demand – at least until the catalyst of easy money and negative rates vanishes Chart I-7Gold Prices And Real Yields Gold Prices And Real Yields Gold Prices And Real Yields Chart I-8Gold Is A Giffen Good Gold Is A Giffen Good Gold Is A Giffen Good There is reason to believe that the bull market in gold might be sustained for longer this time around. The reason is that central banks have become important (and price-insensitive) buyers. Foreign central banks have been amassing almost all of the gold annual output in recent years. It is remarkable that for most of the dollar bull market this past decade, the world’s major central banks (and biggest holders of US Treasurys) have seen rather stable exchange rates relative to the gold price (Chart I-9). This suggests that gold price risks could be asymmetric to the upside. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and boosts the value of gold foreign exchange reserves. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. While we like gold, more value can be found in silver (and even platinum) prices, which have lagged the run up in gold. During precious metals bull markets, prices tend to move in sequence, starting with gold, then silver. Meanwhile, the gold/silver ratio (GSR) tends to track the US dollar (Chart I-10), since silver tends to rise and fall more explosively than gold. Part of the reason is that the silver market is thinner and more volatile. Silver’s rising industrial use has also led to competition with investment demand in recent years. Chart I-9Central Banks Will Put A Floor Under Gold Prices Central Banks Will Put A Floor Under Gold Prices Central Banks Will Put A Floor Under Gold Prices Chart I-10Silver Should Outperform Gold As The Dollar Falls Silver Should Outperform Gold As The Dollar Falls Silver Should Outperform Gold As The Dollar Falls The next important technical level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did. Globally, the world produces much more gold than silver, with a supply ratio that is 7:1. Meanwhile, the price ratio between gold and silver is near 70:1. Back in the 1800s, Isaac Newton concluded that the appropriate ratio was 15.5:1. We initially shorted the GSR at 100 and eventually took 25% profits when our rolling stop was triggered. We recommend putting a limit sell at 75. More speculative investors can buy silver outright. Stay Short NZD At The Crosses, Especially Versus The CAD Chart I-11Stay Long CAD/NZD Stay Long CAD/NZD Stay Long CAD/NZD In our currency portfolio, trades at the crosses are equally important as versus the USD in terms of adding alpha. Over the past year, we have successfully been playing the short side of the kiwi trade. We closed our long SEK/NZD trade for a profit of 7.8% on March 20, and our long AUD/NZD trade for a profit of 5.2% on June 26. Today, we remain bullish on the CAD/NZD as an exploitable trading opportunity. First, the New Zealand stock market is the most defensive in the G10, while Canadian bourses are heavy in cyclical stocks. Should value start to outperform growth, this will favor the CAD/NZD cross. Second, immigration was an important source of labor for New Zealand, and COVID-19 has eaten into this dividend for the economy. As such, the neutral rate of interest is bound to head lower. And finally, in the commodity space, our bias is that energy will fare better than agriculture, boosting Canada’s relative terms of trade. At the Bank of Canada’s meeting this past Wednesday, the tone was slightly optimistic as it kept rates on hold. Recent data has been rather strong in Canada, especially in housing and goods consumption. This allows for the possibility of the BoC tapering asset purchases faster than the market expects, as argued by my colleague Mathieu Savary. This arbitrage is already being reflected in real interest rates, where they offer a premium of 180 basis points in Canada relative to New Zealand (Chart I-11). What To Do About Sterling? Trade negotiations between the UK and EU are once again hitting a brick wall. The key issue is around Northern Ireland. Ireland wants to remain bound to the EU’s customs and trade regime. The UK is seeking an amendment to be able to intervene, if there is “inconsistency or incompatibility with international or domestic law.” In short, it allows for UK discretion in the movement of goods to and from Northern Ireland, as well as state aid to Northern Ireland. The EU argues this is a clear breach of the treaty agreed to last year.    We remain bullish on the CAD/NZD as an exploitable trading opportunity. As negotiations go on, our base case is that a deal will eventually be reached. This is because neither side wants the worst-case scenario, namely, a no-deal Brexit. Should no deal be reached, the sharp rise in the trade-weighted euro will be exacerbated by a drop in the pound. This is deflationary for the euro area. And while the drop in the pound could be beneficial to the UK in the longer term, it will be very destabilizing since the UK is highly dependent on capital flows. Our roadmap for sterling is as follows: Historically, odds of a “hard” Brexit have usually been associated with cable near 1.20. This occurred after the UK referendum in 2016 and after Prime Minister Boris Johnson was elected with a mandate to take the UK out of the EU (Chart I-12). Intuitively, this suggests that maximum pessimism on the pound, driven by Brexit fears, pins cable at around 1.20. A “weak” deal cobbled together at the eleventh hour will still benefit cable. Depending on the details, 1.35-1.40 for cable will be within striking distance. In the case where both the UK and EU come to a “perfect” agreement, the pound could be 20%-25% higher. The real effective exchange rate for the pound is now lower than where it was after the UK exited the ERM in 1992, with a drawdown that has been similar in size. A good deal should cause the pound to overshoot the mid-point of its historical real effective exchange rate range (Chart I-13). Chart I-12GBP Has Historically Bottomed At 1.20 GBP Has Historically Bottomed At 1.20 GBP Has Historically Bottomed At 1.20 Chart I-13The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap The pound is also cheap versus the euro, and we expect the EUR/GBP to start facing significant headwinds near 0.92. It is remarkable that UK data continues to outperform both the US and euro area (Chart I-14). As such, cable should be bought on weakness. Tactically, we would be buyers of the pound in the 1.24-1.25 zone, and our limit sell on EUR/GBP was triggered yesterday at 0.92.   Chart I-14The UK Economy Is Improving The UK Economy Is Improving The UK Economy Is Improving Thoughts On The ECB The main takeaways from the European Central Bank (ECB) conference were threefold. First, data in the euro area was better than the ECB expected. Second, the ECB did not give any hints on its policy review or extend forward guidance. Keeping policy easy until inflation is up to, but still below, 2% appears more hawkish than the Federal Reserve, which is now trying to asymmetrically generate inflation. And finally, the ECB said they are monitoring the exchange rate, but fell short of providing any hints that they will actively lean against the currency. The euro took off, both against the dollar and other European currencies. We outlined in last week’s report why we do not believe the euro can fall much from current levels. These include the common currency being cheap and having a large share of exports in the eurozone. A Few Words On The CHF Finally, a few clients have asked what happens to the Swiss franc in an environment where the euro is rising (and the dollar is falling). Our bias is that the Swiss National Bank lets a rising EUR/CHF ease financial conditions in Switzerland, and even leans into it. The Swiss National Bank has been stepping up its pace of intervention since EUR/CHF touched 1.05 this year and will continue to do so (Chart I-15). Unfortunately, there is not much it can do about a falling USD/CHF. This suggests the franc will fall against the euro, but not so much against the dollar. In a world where global yields eventually converge to zero, holding the Swiss franc is an attractive hedge. Chart I-15USD Weakness Will Be A Headache For The SNB USD Weakness Will Be A Headache For The SNB USD Weakness Will Be A Headache For The SNB   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 from the US have been positive: On the labor market front, nonfarm payrolls fell to 1371K from 1734K in August. The average hourly earnings increased by 4.7% year-on-year. The unemployment rate declined from 10.2% to 8.4%. Initial jobless claims increased by 884K for the week ending on September 4th.  Finally, the NFIB business optimism index increased from 98.8 to 100.2 in August. The DXY index initially rose to a 4-week high of 93.6 earlier this week with positive data releases, then fell back to 93. Our bias is that while the dollar has been rebounding since the beginning of the month, the rally could prove to be a healthy counter-trend move in the long-term dollar bear market. Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 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 from the euro area have been mixed: The Sentix investor confidence increased from -13.4 to -8 in September. GDP plunged by 11.8% quarter-on-quarter in Q1, or 14.7% year-on-year.  The euro declined by 0.5% against the US dollar this week. The ECB decided to keep its interest rate and PEPP program unchanged on this Thursday. President Christine Lagarde sounded quite hawkish in the press conference, saying that incoming data since the last monetary policy meeting suggest “a strong rebound in activity broadly in line with previous expectations.” We continue to favor the euro against the US dollar. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 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 from Japan have been mixed: The coincident index increased from 74.4 to 76.2 in July. The leading economic index also climbed up from 83.8 to 86.9 in July. The current account balance widened from ¥167 billion to ¥1,468 billion in July. GDP plunged by 7.9% quarter-on-quarter in Q2, or 28.1% on an annualized basis. Preliminary machine tool orders continued to fall by 23.3% year-on-year in August. Overall household spending contracted by 7.6% year-on-year in July. The Japanese yen appreciated by 0.2% against the US dollar this week. The expansion in Japan’s current account balance is mainly driven by the decline in domestic demand. Exports fell by 19.2% year-on-year in July while imports slumped at a faster pace by 22.3%. This suggests that deflationary forces are returning to Japan, which will boost real rates and buffet the yen. 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 from the UK have been mostly positive: Retail sales continued to increase, rising by 4.7% year-on-year in August, following a 4.3% increase the previous month. Halifax house prices increased by 5.2% year-on-year for the 3 months to August. The Markit construction PMI declined from 58.1 to 54.6 in August. The British pound extended its sell-off this week, depreciating by 2.5% against the US dollar, making it the worst-performing G10 currency. Under ongoing trade negotiations, the possibility of a no-deal Brexit is now putting more downward pressure on the pound after the summer rally. 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 from Australia have been mixed: The AiG services performance index fell from 44 to 42.5 in August. The NAB business confidence increased from -14 to -8 in August while the business conditions index fell from 0 to -6. The Australian dollar appreciated by 0.4% against the US dollar this week. Spending fell sharply during the pandemic, pushing Australia’s savings rate to 19.8% from 6%. Until consumer spending returns in earnest, the RBA is unlikely to raise rates, which puts a cap on how far the AUD can rise. The good news is that household balance sheets are being mended, which reduces macroeconomic risk. 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 from New Zealand have been mixed: Manufacturing sales plunged by 12.2% quarter-on-quarter in Q2. The preliminary ANZ business confidence index increased from -41.8% to -26% in September. The ANZ activity outlook index also ticked up from -17.5% to -9.9%. The New Zealand dollar fell initially against the US dollar, then recovered, returning flat this week. The ANZ New Zealand Business Outlook shows that most activity indicators have increased to the highest levels since the beginning of the pandemic but are still well below pre-COVID-19 levels. We like the New Zealand dollar against the US dollar but believe that it will underperform against other pro-cyclical currencies including the Australian dollar and the Canadian dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: On the labor market front, the unemployment rate declined from 10.9% to 10.2% in August. The participation rate increased from 64.3% to 64.6%. Average hourly wages surged by 6% year-on-year in August. Housing starts increased by 6.9% month-on-month to 262.4K in August, the highest reading since 2007. The Canadian dollar depreciated by 0.3% against the US dollar this week. The Bank of Canada maintained its target rate at 0.25% on Wednesday. It is also continuing large-scale asset purchases of at least C$5 billion per week of government bonds. Moreover, the Bank suggested that the bounce-back in activity in Q3 was better than expected, which bodes well for the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been mixed: FX reserves continued to increase from CHF 847 billion to CHF 848 billion in August. The unemployment rate remained unchanged at 3.4% in August. The Swiss franc appreciated by 1% against the US dollar this week. The SNB Chairman Thomas Jordan said that “stronger currency market interventions relieve over-valuation pressure on the Swiss franc and protect the Swiss economy”. Recent dollar weakness could be another headache for the SNB, accelerating SNB’s currency intervention. While we like the franc as a safe-haven hedge with high real rates, the upside potential is likely to be more gradual as the SNB leans against it. 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 from Norway have been positive: Manufacturing output increased by 1.8% month-on-month in July. Headline consumer price inflation ticked up from 1.3% to 1.7% year-on-year in August. Core inflation continued rising to 3.7% year-on-year from 3.5% the previous month. The Norwegian krone depreciated by 0.5% against the US dollar this week. The increase in headline inflation was mainly driven by furnishings and household equipment (10%), communications (4.9%) and food (3.7%). However, the Norwegian krone is still tremendously undervalued against the US dollar according to our models. 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 from Sweden have been mostly positive: The current account surplus fell to SEK 63.2 billion in Q2 from SEK 75.5 billion in Q1. However, this compares favorably to a surplus of SEK 34.7 billion the same quarter last year. Manufacturing new orders continued to fall by 6.4% year-on-year in July. This is an improvement compared to the 13.1% contraction the previous month. Headline consumer prices inflation increased from 0.5% to 0.8% year-on-year in August. Core inflation also climbed up from 0.5% to 0.7% year-on-year. The Swedish krona appreciated by 0.5% against the US dollar this week. We continue to favor the Swedish krona amid global economy recovery. Moreover, our PPP model shows that the krona is still undervalued by 19% against the US dollar. 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