Financial Markets

Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1  last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan.  First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2  they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. 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 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. 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 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. 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 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. 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 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. 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 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. 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 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a  rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month.  The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. 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 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May.  The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction.  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 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April.  PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. 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 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. 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

Highlights US dry gas production – the gas traded on futures exchanges and consumed by firms and households – is expected to fall ~ 2.5% this year to 89.7 bcf/d.  Consumption will be down ~ 4% to 74.3 bcf/d.  High carryout stocks from a warmer-than-normal winter mean US natgas storage will be at a record 4 TCF by November.  This is close to demonstrated peak capacity of 4.3 TCF. We expect US benchmark Henry Hub futures prices to average $2.00/MMBtu in 2H20, assuming a normal winter (Chart of the Week).  This is slightly lower than current futures’ levels.  A deeper round of demand destruction from a second wave of COVID-19 remains a risk to commodities generally.  Our base case assumes accommodative policy globally will spur a recovery in gas demand next year.  This will push benchmark US prices into the $2.25-$2.50/MMBtu range, which also is below the level futures currently are trading. Weather-related risk is peaking right now.  The early start to the hurricane season will keep demand for storage gas elevated into October.  Local-distribution companies will be planning for normal winter temperatures, which would be colder than last year. Feature Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. US natgas prices will recover slowly in 2H20 and pick up steam in 2021 as demand recovers and LNG export growth resumes. However, we do not expect prices to rally to the extent futures currently are pricing in, nor as much as the US EIA expects. The NYMEX benchmark natgas futures, which call for delivery of pipeline quality dry gas at Henry Hub, LA, were on track to average close to $2.00/MMBtu this year and $2.64/MMBtu next year earlier this week.1 The EIA, for its part, is forecasting $2.04/MMBtu and $3.08/MMBtu for 2020 and 2021, respectively. Our modeling, shown in the Chart of the Week, leads us to expect natgas futures to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively. Our natgas price models use the EIA’s fundamental inputs – supply, demand and working gas storage levels – and temperature and financial variables to explain and forecast prices, including 10-year average heating-degree days, and US Treasury rates. Chart of the WeekUS Natgas Prices Recover Slowly On the supply side, the rate of growth in US natgas production started rolling over in 4Q19, well before COVID-19 was even an issue for the market. A warmer-than-normal winter last year weakened prices sufficiently to cause natgas production in the US shales to roll over from a high of 86 billion cubic feet per day (bcf/d) in 4Q19, to 84 bcf/d in the first five months of 2020. Shales account for ~ 90% of total US gas production. In and of itself, this is a relatively small impact, reflecting more the unintended inventory accumulation following last winter. Shale-Gas Production Rolls Over The decade-long shale-gas production surge led by the Marcellus formation in the US Appalachian Mountain region and, more recently, the Permian basin in Texas, which together account for ~ 60% of US gas production, ended – for the time being – in 4Q19 (Chart 2). Total natgas production in the Lower 48 states rose 11% in 2019 to 95.6 bcf/d, and is expected to fall ~ 2% this year to 93.7 bcf/d. Chart 2Shale-Gas Production Rolled Over Following A Warm 2019-20 Winter Natgas production is sensitive to the level of US short-term rates. The financial variables in our model indicate natgas production is sensitive to the level of US short-term rates, which the Fed has been maintaining at low levels since the Global Financial Crisis (GFC) to battle disinflation. Natgas is a derived demand – it is used to heat buildings and generate electricity, e.g. – so anything that lifts demand will benefit supply (Chart 3). In our modeling, we find natgas production is an explanatory variable for natgas consumption, but not vice versa, suggesting that the supply side is aggressively pricing to meet demand, and increase market share at the expense of coal-fired generation (Chart 4). Chart 3US Natgas Production, Consumption Are Sensitive to US Treasurys Chart 4Low Rates Accelerate Coal's Market Share Loss To Natgas Shale-gas production also is being weakened in the US by the collapse in oil prices, particularly in the Permian basin, where associated natural gas output has been surging (Chart 5).2 Close to 500 Bcf of natural gas was flared in the Bakken and Permian plays.3 This means the collapse in crude-oil prices on net is lowering CO2 emissions associated with flaring in Texas and North Dakota.4 Chart 5Associated Gas Production Falls As Crude Oil Prices Weaken Chart 6Warm Winter Destroys Natgas Demand Gas Consumption Growth Slows The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. Gas consumption was hammered by a much warmer-than-average winter last year (Chart 6). This left the level of working gas in storage at ~ 2 TCF by the end of March 2020, when the heating season ended (Chart 7). Natgas working storage has continued to increase every month since, and now stands just below 3 TCF, according to the EIA’s latest estimate. The US EIA expects working gas in storage to reach 4 TCF, a record, by the start of the heating season in November. The latest estimate of demonstrated peak storage capacity is 4.26 TCF, which raises the possibility a warm winter this year could lead to a full-storage event.5 Should this happen, markets would begin pricing the probability – not the possibility – of negative natural gas prices in more than just local markets lacking pipeline takeaway capacity or sufficient storage to accommodate local supply and demand imbalances. Chart 7US Working Gas In Storage Continues To Build Toward 4 TCF Negative natgas prices would further exacerbate the risk of more sharp curtailments in oil and gas capex – in addition to the $400 billion projected by the International Energy Agency (IEA) last month, which would cut shale-oil and -gas capex by 50%.6 This could set up a huge rally in hydrocarbons generally, oil and gas in particular, should it occur. Beware Disorderly Gas Markets As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. At the end of April, we noted the disorderly termination of trading in WTI futures delivering in May to Cushing, OK, was among the proximate causes of futures falling to -$40.32/bbl – that’s $40.32/bbl below $0.00/bbl – prior to the contract going off the board. Partly, we contend, this was the result of a failure of the US Commodity Futures Trading Commission (CFTC) and the CME Group, which operates WTI crude oil and Henry Hub natgas futures markets, to ensure only bona fide hedgers with the capacity to make or take delivery of the physical commodity being traded via futures contracts were left in the market as these contracts went to delivery. As US natgas working storage fills going into the winter heating season, markets will once again be watching to see if the CFTC and CME are capable of maintaining orderly terminations of trading under physical-market stress, which a full-storage event certainly qualifies as. Another failure to ensure an orderly termination of trading would add another impediment to sourcing capital for oil and gas producers – many producers chose to or are forced to hedge – which would exacerbate a tightening of supply in the medium term (2 to 3 years hence). Bottom Line: We expect natgas futures delivering to Henry Hub, LA, to average $1.92/MMBtu and $2.22/MMBtu this year and next, respectively, based on our proprietary models using fundamental and financial explanatory variables. Upside risks to the forecast are a stronger-than-expected demand recovery, which sees residential, commercial, industrial and electric-generation demand reviving sharply. A global pick-up that increased demand for LNG also would rally US gas prices sharply. To the downside, another round of demand destruction from a second wave of the COVID-19 pandemic would press prices lower. As US working gas in storage increases, the risks of a full-storage event rises. This will force market participants to price in a higher probability of negative prices, which also would have a deleterious impact on capex and, thus, future supplies.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight US shale E&P companies are bringing back some of their shut-in production as WTI prices remain above $35/bbl. According to Rystad Energy, more than 300k b/d of previously shut-in production is already coming back online as of June. Nonetheless, rig count remains at its lowest level since 2009 and prices are not high enough to incentivize additional drilling. Our estimates suggest the return of shut-in production will pale compared to the drop in production from natural decline rates over the coming months. Base Metals: Neutral In its June Global Economic Prospects, the World Bank revised its emerging market and developing economies real GDP growth estimates for 2020 to -2.5%, a 6.6pp downward revision from its January 2020 projections. On the other hand, China’s credit numbers continue to move up, reaching 30% of nominal GDP in May (Chart 8). Going forward, the recovery in base metals hinges on the speed at which the stimulus reaches the real economy. On average, it takes somewhere between 4 to 9 months for metals to react to surges in China’s TSF. Precious Metals: Neutral Gold prices traded between $1,675/oz and $1,760/oz since April. Our fair-value model suggests prices could trade slightly below this range (Chart 9). However, risks of renewed US-China tensions are rising rapidly, which could keep gold well-bid. BCA Research’s China Investment strategists believe these risks will reach new height over the summer as pressure on Trump’s election campaign intensifies.7 Mounting geopolitical risks could hurt risk assets and benefit gold as a hedge against equity volatility. Ags/Softs:  Underweight July Ethanol futures have shown substantial strength in the past two months, but the outlook remains gloomy. With over 30% of US fuel ethanol plants being idled during the pandemic, as prices and margins increase, an increase in supply is likely.  Gasoline demand might have less room to grow as most individuals keep working from home. Supporting this is EIA’s STEO outlook which sees the ethanol market oversupplied in 2020, with consumption expected to average 800k b/d in 2020 and production to average 880k b/d. Chart 8Chinese Credit Growth To Rise Chart 9Gold Slightly Above Fair Value     Footnotes 1     Pipeline-quality dry natural gas has had all impurities (metals, sulfur compounds, etc.) and non-methane liquids removed so that its heat content is ~ 1,010 BTUs per cubic foot. The NYMEX futures taken to delivery at Henry Hub, LA, require physical gas to meet the specifications “set forth in the FERC-approved tariff of Sabine Pipe Line Company.” 2     TThe correlation between US natgas and oil prices declined substantially since 2009. Our model, based on WTI prices and 10-year US treasury yields only, suggests Henry Hub prices’ elasticity to changes in oil prices dropped by more than 50% post-GFC. On the other hand, US yields are now much closely related to natural gas prices. The disconnection between Henry Hub and WTI prices is largely a result of the large increase in shale gas and associated gas production. Strong oil prices –which are determined globally – incentivized higher output by US E&Ps. This led to a surge in the volume of associated gas in an already saturated domestic gas market. 3    Please see Lingering Oil-Demand Weakness Will Fade, which we published November 21, 2019, and discusses flaring in the Permian and Bakken basins. 4    Please see "U.S. oil fields flared and vented more natural gas again in 2019: data" published by reuters.com February 3, 2020. 5    Please see Underground Natural Gas Working Storage Capacity published by the EIA May 29, 2020, for additional detail. 6    Please see The Covid-19 crisis is causing the biggest fall in global energy investment in history, published by the IEA May 27, 2020. The Agency notes, “… after the Covid-19 crisis brought large swathes of the world economy to a standstill in a matter of months, global investment is now expected to plummet by 20%, or almost $400 billion, compared with last year.” Oil and gas investment is projected to fall more than 30%. 7     Please see BCA Research's China Investment Strategy Report entitled Watch Out For A Second Wave (Of US-China Frictions) published June 10, 2010, available at cis.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed In 2020 Summary of Closed Trades  

Please note that yesterday we published Special Report on Egypt recommending buying domestic bonds while hedging currency risk. Today we are enclosing analysis on Hungary, Poland and Colombia. I will present our latest thoughts on the global macro outlook and implications for EM during today’s webcast at 10 am EST. You can access the webcast by clicking here. Yours sincerely, Arthur Budaghyan Hungary Versus Poland: Mind The Reversal Conditions are set for the Hungarian forint to outperform the Polish zloty over the coming months. We recommend going long the HUF against the PLN. Hungarian opposition parties criticized the government about the considerable depreciation in the forint. As a result, we suspect that political pressure from Prime Minister Viktor Orban led monetary authorities to alter their stance since April. Critically, the main architect of super-dovish monetary policy Marton Nagy resigned from the board of the central bank on May 28. In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. The Hungarian central bank (NBH) tweaked its monetary policy in April after the currency had plunged to new lows against the euro, underperforming its Central European counterparts. The NBH widened its policy rate corridor by hiking the upper interest band to 1.85% and keeping the policy rate at 0.90%. The wider interest rate corridor makes it more costly for commercial banks to borrow reserves from the central bank. Hence, such liquidity tightening is positive for the forint. For years, Hungary was pursuing a super-easy monetary policy and consumer price inflation rose to 4% (Chart I-1). With the NBH keeping interest rates close to zero, real rates have plunged well into negative territory (Chart I-2, top panel). Chart I-1Hungary: Inflation Could Pause For Now Chart I-2Hungary Vs. Poland: Real Rates Reversal Is Coming     In brief, the central bank has been behind the inflation curve. As a result, the forint has been depreciating against both the euro and its central European peers. In such a situation, the key to reversal in the exchange rate trend would be the monetary authority’s readiness to raise real interest rates. The NBH has made a small step in this direction. Going forward, the central bank will be restrained in its quantitative easing (QE) program and will not augment it any further. So far, QE uptake has been slow: around half out of the available HUF 1,500 billion has been tapped by commercial banks and corporates. Importantly, the NBH announced its intention to sterilize its government and corporate bond purchases. Already, the commercial banks excess reserves at the central bank have fallen to zero, which suggests that liquidity is no longer abundant in the banking system (Chart I-3). In line with tighter liquidity, interbank rates have risen above the policy rate. This is marginally positive for the forint. Hungarian authorities have become more cognizant of the economic and financial risks associated with their ultra-accommodative policies. For instance, they initiated a clampdown on real estate speculation, which is leading to dwindling real estate prices. This will lead to a decline in overall inflation expectations and, thereby, lift expected real interest rates. The open nature of Hungary’s economy – whereby exports of goods and services constitute 85% of GDP - makes it much more sensitive to pan-European tourism and manufacturing cycles. With the collapse in its manufacturing and tourism revenues, wage growth in Hungary is bound to decelerate rapidly (Chart I-4). Chart I-3Hungary: Central Bank Has Drained Liquidity Chart I-4Economic Growth: Hungary Is More Vulnerable Than Poland   Rapidly deteriorating wage and employment dynamics reduces the odds of an inflation breakout anytime soon. This will cool down inflation and, thereby, increase real rates on the margin. The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. Bottom Line: Although this monetary policy adjustment does not entail the end of easy policy in Hungary, generally, it does signal restraint on the part of monetary authorities resulting from a much reduced tolerance for currency depreciation. This creates conditions for the forint to outperform. Poland In the meantime, Polish monetary authorities have switched into an ultra-accommodative mode. Recent policy announcements by the National Bank of Poland (NBP) represent the most dramatic example of policy easing in Central Europe. Such a policy stance in Poland will produce lower real rates than in Hungary, which is negative for the Polish zloty against the forint. The NBP is set to finance the majority of a new 11% of GDP fiscal spending program enacted by the government amid the COVID-19 lockdowns. This amounts to de-facto public debt and fiscal deficit monetization. The latter will not be sterilized unlike in Hungary and will therefore lead to an excess liquidity overflow in the banking system. The Polish central bank has cut interest rates by 140 bps to 10 bps since March. Pushing nominal rates down close to zero has produced more negative real policy rates than in Hungary (Chart I-2, top panel on page 2). Also, Polish prime lending rates in real terms have fallen below those in Hungary (Chart I-2, bottom panel). Chances are that inflation in Poland will also prove to be stickier than in Hungary due to the minimum wage raise at the beginning of the year and very aggressive fiscal and monetary stimulus since the pandemics has erupted (Chart I-5). Critically, the Polish economy is much less open than Hungary’s, and it is therefore less vulnerable to the collapse of pan-European manufacturing and tourism. This will ensure better employment and wage conditions in Poland. All in all, Poland’s final demand outperformance, versus Hungary, will contribute to a higher rate of inflation there. Bottom Line: The central bank in Poland will stay super accommodative while the National Bank of Hungary will be a bit less aggressive. This is producing a U-turn in both countries’ nominal and relative real interest rates, which heralds a reversal in the HUF / PLN cross rate (Chart I-6). Chart I-5Polish Inflation Will Be Sticker Than In Hungary Chart I-6Go Long HUF / Short PLN   Investment Strategy For Central Europe A new trade: go long the HUF versus the PLN. Take a 3% profit on the short HUF and PLN / long CZK trade. Close the short IDR / long PLN trade with a 20% loss. Downgrade central European bourses (Polish, Czech and Hungarian) from an overweight to a neutral allocation within the EM equity benchmark. Lower for longer European interest rates disfavor bank stocks that dominate central European bourses. Andrija Vesic Associate Editor andrijav@bcaresearch.com Colombia: Continue Betting On Lower Rates Colombia has been badly hit by two shocks: the precipitous fall in oil prices and the strict quarantine measures to constrain the spread of the COVID-19 outbreak. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. An underwhelming fiscal stimulus in response to the lockdowns will further weigh on private demand. We have been recommending receiving 10-year swap rates in Colombia since April 23rd and this strategy remains unchanged: While oil prices seem to have rebounded sharply, they will remain structurally low (Chart II-1). The Emerging Markets Strategy team's view is that oil prices will average $40 per barrel this year and next.1 After the recent rally, chances of further upside in crude prices are limited. Chart II-1A Long-Term Perspective On Oil Prices Table II-1Colombia’s Fiscal Package Is The Lowest In The Region Colombia's high sensitivity to oil prices is particularly visible via its current account balance. Indeed, Colombia’s net crude exports cover as much as 50% of the current account deficit, such that low oil prices severely affect the currency and produce a negative income shock for the economy. Fiscal policy remains unreasonably tight, especially in the face of the global pandemic. The government’s fiscal response plan amounts to only a meagre 1.5% of GDP. This is low not only compared to advanced economies but also to the rest of Latin America (Table II-1). Moreover, President Duque’s administration has been running the tightest fiscal budget in almost a decade, with the primary fiscal balance reaching 1% of GDP before the pandemic. The country’s COVID-19 response has been fast and effective. Colombia has managed to achieve the lowest amount of infections and deaths among major economies in Latin America (Chart II-2). Chart II-2COVID-19 Casualties Across Latin America Duque’s administration has taken a pragmatic approach to handling the pandemic by enforcing strict lockdowns and banning international and inter-municipal travel since late March, only three days after the country’s first casualty. Further, the nationwide confinement measures have been extended until July 1st, with particularly stringent rules applying to major cities. These have helped the country avoid a nation-wide health crisis, but they will engender prolonged economic pain. Regarding monetary stimulus, the central bank (Banrep) has cut interest rates by 150 basis points since March of this year. It also embarked on the first and largest QE program in the region. Banrep has committed to purchase 12 trillion pesos worth of government and corporate securities (amounting to a whopping 8% of GDP). Consumer price inflation is falling across various core measures and will drop below the low end of Banrep’s target range (Chart II-3). This will push the central bank to continue cutting rates. Despite the monetary easing, nominal lending rates are still restrictive. Real lending rates (deflated by core CPI) remain elevated at 7% (Chart II-4). Chart II-3Colombia: Inflation Will Fall Below Target Chart II-4Colombia: Real Lending Rates Are Still High Chart II-5The Colombian Economy Was Already Under Pressure Importantly, there has not been an appropriate amount of credit support and debt waving programs for SMEs, as there has been in many other countries. Given that SMEs employ a large share of the workforce, and that household spending accounts for about 70% of GDP, consumer spending and overall economic growth will contract substantially and be slow to recover. Employment rates had already been contracting, and wage growth downshifting, before the pandemic started (Chart II-5). Household income is now certainly in decline as major cities are in full lockdown and economic activity is frozen. Investment Recommendations Even though we are structurally positive on the country due to its orthodox macroeconomic policies, positive structural reforms, and low levels of debt among both households and companies, we maintain a neutral allocation on Colombian stocks within an EM equity portfolio. This bourse is dominated by banks and energy stocks. The lack of both fiscal support and bank loan guarantees amid the recession means that banks will carry the burden of ultimate losses. They will suffer materially due to loan restructuring and defaults. For fixed income investors, we reiterate our call to receive 10-year swap rates and recommend overweighting local currency government bonds versus the EM domestic bond benchmark. The yield curve is steep and real bond yields are elevated (Chart II-6). Hence, long-term interest rates offer great value. Additional monetary easing, including quantitative easing, will suppress yields much further. Chart II-6A Great Opportunity In Colombian Rates Chart II-7The COP Has Depreciated Considerably   We are upgrading Colombia sovereign credit from neutral to overweight within an EM credit portfolio. General public debt (including the central and state governments) stands at 59% of GDP. Conservative fiscal policy and the central bank’s large purchases of local bonds will allow the government to finance itself locally. Presently, 40% of public debt is foreign currency and 60% local currency denominated. As a result, sovereign credit will outperform the EM credit benchmark. In terms of the currency, we recommend investors to be cautious for now. Even though the peso is cheap (Chart II-7), another relapse in oil prices or a potential flare up in social protests could cause further downfall in the currency. Juan Egaña Research Associate juane@bcaresearch.com   1 This differs from the view of BCA’s Commodities and Energy Strategy service. We believe structural forces such as the lasting decline in air travel and commuting will impede a recovery in oil demand while, at the same time, US shale production will rise again considerably if crude prices rise and remain well above $40   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend Chart I-10Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP   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 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Volatility strategies are a useful tool for asset allocators. They can be used for both alpha generation and risk mitigation, but they have to be managed properly within a fund’s total risk management framework. Dedicated tail-risk hedging can reduce volatility, but can be very costly depending on the holding period. Short volatility strategies can generate alpha, but can also incur large losses when volatility spikes. Long volatility and also relative-value volatility strategies are much better alpha generators. A simple and easy-to-implement rule-based dynamic hedging strategy using short-term VIX futures reduces equity portfolio risk significantly without sacrificing return. The Sensational Headlines The COVID-19 pandemic-induced financial market volatility has put two major pension funds in the proverbial spotlight. First, CalPERS was questioned about its October 2019 decision to unwind its tail-risk hedging program that would have generated a payoff of more than US$1 billion during the March equity market selloff.1 Then, AIMCo was said to have lost over C$3 billion in its short volatility program, and was also forced to shut the program down.2 With such high-profile stories making the rounds, it is not surprising that we have received questions about tail-risk hedging and volatility strategies from many clients: Should long-term investors hedge tail risk? Is short volatility not a suitable strategy for pension funds? What are the efficient ways to manage large drawdowns? Chart 1The High Profile Failures: Not Uncommon Before we attempt to answer these questions, we want to first point out that tail-risk hedging and short-volatility strategies are negatively correlated, as shown in Chart 1, panel 1. It is normal for short-volatility strategies to suffer large drawdowns when tail-hedging strategies make handsome gains in periods of extreme financial market stress. This is largely due to the nature of volatility. As shown in panel 2 in Chart 1, VIX futures curves are normally in contango (the far-month contract is higher than the near-month contract), so a plain-vanilla short position in VIX futures benefits from positive rolling yields, while a plain-vanilla long position suffers from negative rolling yields. When VIX spikes, however, the futures curve turns into large backwardation (the far-month contract is lower than the near-month contract) in a fast and furious fashion, hence the large insurance-like payoff. The short-volatility and tail-hedge indexes in Chart 1 are from CBOE Eurekahedge, which has a suite of volatility indexes. As shown in Table 1, these indexes track the average performance of hedge funds that employ various volatility strategies, including tail-risk volatility, long volatility, short volatility and relative-value volatility. Table 1CBOE Eurekahedge Volatility Hedge Fund Indexes*  The performance statistics of these indexes are shown in Table 2. It is clear that not all volatility strategies are created equal. Below, we explore in more detail how these strategies should be used. Table 2CBOE Eurekahedge Volatility Index Performance Statistics Tail-Risk Hedging Is Not Free Tail-risk hedging has been in the news of late, given the unprecedently sharp drop in equities in February and March and also the untimely decision by CalPERS to unwind its tail-risk hedging program last October. So, what is tail-risk-hedging exactly? How does it work? Tail-risk hedging strategies aim to profit from large drawdowns in risky assets. Unlike the traditional approach of diversification that reduces the weighting of risky assets (for example, a 60-40 equity-bond portfolio is less risky than a 100% equity portfolio), tail-risk hedging attempts to allocate a small percentage of capital, say 3-5%, to a specially designed insurance-like payoff, while maintaining exposure to the risky asset. As such, tail-risk hedging is like buying an insurance policy against a catastrophic event. The premiums paid may or may not be recouped, depending on how likely it is that a catastrophic event may occur and how long one has held the insurance policy. The Universa Tail Fund is one of the two tail-risk funds that CalPERS made the untimely decision to redeem. The fund returned 3,600% in March alone, and 4,440% in the first quarter of 2020. As well, according to reports, a portfolio with 96.7% in the S&P 500 and 3.3% in Universa’s tail-risk fund would effectively have mitigated the S&P 500’s large loss in March, and would have also produced a compounded return of 11.5% since March 2008 versus 7.9% for the S&P 500.3  The performance of the Universa Tail Fund seems to be very different from the average hedge fund in this category, as shown in Table 2 and Chart 1. The CBOE Eurekahedge Tail Risk Hedge Fund index is an average of eight hedge funds that employ tail-risk strategies to achieve capital appreciation during periods of market stress. Since December 2007, when the index started, it has had two outsized monthly gains: 37.5% in March 2020 and 27.5% in August 2011, when MSCI US equities lost 12.7 and 5.5%. However, such benefit is very costly from a long-term perspective because the index has generated an annualized loss of 2.5%, even through April 2020. Its arithmetic average during the period is about -1.6%. To better understand why Universa has been doing so much better than the “average” tail risk hedge fund, we replicate a stylized exercise by Universa published in October 2017.4 The only difference is that we use the MSCI US equity total return index instead of the S&P 500 index. The payoff structure of 9 to 1 means that when the MSCI US calendar year return is less than -15%, the hedge would generate a return of 900%. In other years, insurance premium is not recouped at all, i.e. there is a loss of 100%. The original exercise by Universa designed such a payoff structure because it aimed to have an average payoff of zero in the period from 1996 to 2016. As shown in Chart 2, the biggest advantage of the tail-hedged portfolio (97% MSCI US + 3% Insurance) is its much smoother return stream, with a standard deviation of 12.9% compared to 17.7% for the unhedged MSCI US equity portfolio based on calendar year returns from 1970 to 2020 (as of March for 2020). Also, the skew is improved to -0.1 from -0.7. In terms of return, however, it is highly variable depending on the period chosen. The hedged portfolio outperformed the MSCI US total return index by about 70 basis points annualized from 1996 to 2016, consistent with the result from the original exercise by Universa.5 Outside this period, however, the average return of the payoff stream really depends on how often US equities fall below -15% yearly. In the 50-year period from December 1969 to December 2019, the average return of the insurance payoff was -20%, and the tail-hedged program underperformed MSCI US by 26 basis points annualized. Chart 2Universa Exercise Replica* For 12/1969 - 3/2020 This simple stylized exercise shows that both the starting point to initiate the tail-risk hedge and the length of time to hold the hedge are very important for a tail-risk hedge to work, not to mention generate spectacular results. Like a catastrophic insurance policy, a tail hedge should not be considered as a stand-alone strategy but as a hedge to the underlying portfolio. It is critical to design the right payoff structure, which in turn requires a view on how often a large drawdown will likely happen in the forecast period. It also takes special skill to find the right instruments to implement such a payoff structure and manage it accordingly. As we will show in the section on page 9, a dynamic approach is needed to ensure the hedge is on only when it’s needed to reduce cost. In fact, Universa did mention about using extreme valuation as one indicator to identify periods with high likelihood of downside risks.6 It also locked in a massive gain in March 2020,7 another indication of the “dynamic nature” of tail-hedging management. Bottom Line: From a long-term perspective, tail-risk hedge does not significantly improve compound returns, but it does reduce volatility significantly. Unless an investor has the skill to dynamically manage a hedge program, passively holding a tail-risk hedge can be costly in terms of return, even though it does improve risk-adjusted returns. Is A Short-Volatility Strategy Suitable For Pension Funds? The CBOE Eurekhedge Short Volatility index lost 20.8% in the first four months of 2020, in which March was the worst month in its history since December 2004, with a loss of 15.8%, while April was the best month with a gain of 9.3%. The annualized return since December 2004, however, has been 5.4%, and 73% of monthly returns have been in positive territory (Table 2). On the other hand, AIMCo had to shut down its volatility trading program in March because of its large $3 billion loss, or about 2.5% of its $119 billion of AUM. It is not known why a small volatility program was allowed to lose more than the fund’s total full-year value-add target. Chart 3Volatility Measures: Implied Vs. Realized There are different ways to short volatility. One is to sell options on the underlying assets. This approach, however, is also impacted by the price level of the underlying assets. VIX futures, as shown in Chart 1, panel 2, are a way to bet on the change in implied volatility. Another way to short volatility is via variance swaps, which bet on the change between realized variance at the expiry of the swap and the strike variance, which is set according to both historical variance and implied variance.8 Because variance is the square of volatility, the payoff of a variance swap is convex, i.e. when volatility spikes up, a short seller loses more money than when volatility decreases. As shown in Chart 3, VIX, the implied volatility, peaked on March 16, and realized volatility peaked on March 27. However, the difference between realized and implied volatility did not peak until April 6, and remained positive through the end of April. As such, a short volatility program via variance swaps would have experienced severe mark-to-market losses daily from mid-March to early April, even though equities bottomed on March 23.   However, such a spike happened in 2008 as well. Any back-test would have included such an occurrence in 2008. Granted, the magnitude of the current spike is larger than that in 2008, but it reversed quickly down to the 2008 level. We may never know why AIMCo’s short volatility program suffered such outsized losses. The only guess is that it may have used variance swaps, and the embedded leverage made the size of the program not appropriate for the total fund. Bottom Line: Short volatility can be a useful tool for alpha generation. The key, however, is risk management. It should be properly sized within the overall risk management framework of the total fund. Volatility As An Asset Class? Tail-risk hedging using volatility is too costly in general, while shorting volatility outright can be disastrous. Some argue that investors should not have anything to do with volatility strategies. On the other hand, other investors treat volatility as an asset class for both alpha generation and risk mitigation. Chart 4 shows the CBOE Eurekahedge Relative-Value Volatility index and the Long-Volatility index together with the MSCI US equity index, and Bloomberg Barclays US aggregate bond index and US Treasury index. The relative-value volatility index can be long, short, or neutral on volatility (Table 1). As shown in Table 2, it has achieved an annualized return of 7.6%, only 60 basis points less than MSCI US equity return of 8.2%, but much higher than the 4.3% and 4.5% respective return from Bloomberg Barclays US Treasury index and aggregate bond index in the period from December 2004 to April 2020. Its standard deviation of 3.9% is much lower than the MSCI US (14.7%) and very close to Treasurys (4.1%) and aggregate bonds (3.2%). For this specific period, in fact, this index even has a much better risk-return profile than a typical 60/40 US equity/aggregate-bond portfolio, which scores a 7.1% annualized return with 8.9% standard deviation. With almost zero correlation to both stocks and bonds, this index serves as an ideal addition to a balanced equity-bond portfolio (Chart 5). Chart 4Volatility As An Asset Class Chart 5Relative-Value Vol Strategy Improves The Performance Of A 60/40 Equity/Bond Portfolio The challenge, however, is that this index is an average of 35 hedge funds that employ relative-value or opportunistic-volatility strategies that can be long, short, or neutral on implied volatility.9 Because of this, capacity constraints for investors to get into those funds may exist, which could produce diverging performances. Even the long-volatility strategy (Chart 4, panel 2), which in theory suffers negative rolling yields when the VIX is in a normal range, has generated a 5% annualized return. It has a negative correlation of 0.46 with MSCI US equities, comparable to the negative correlation of 0.5 between the Tail-Risk index and MSCI US. Given the much better statistics of this index compared to the Tail-Risk index, it should be a less costly alternative to the Tail-Risk Hedge index (Table 2). To illustrate how these two strategies work to mitigate downside risk in the MSCI US equities, we compare a series of portfolios that allocate from 0-100% of capital to MSCI US and 100-0% to the two volatility strategies, respectively. As shown in Chart 6, the long-volatility strategy is a much better risk mitigator to the MSCI US equities index than the tail-hedge strategy at all levels of allocations for the period from January 2008 to April 2020.  Chart 6Risk Mitigation Using Long Vol Vs. Tail-Risk Hedge Dynamic Hedging Using VIX Futures The CBOE Eurekahedge volatility indexes are based on average returns of the funds in each index. They are not investable. Also, hedge funds in these indexes may have capacity issues to accommodate large investors. In this section we run a simple rule-based hedging strategy using VIX futures to illustrate how investors can use volatility strategies in-house as an alternative tool to mitigate risk. We use the S&P VIX short-term futures index for this exercise, because it can be easily replicated in-house. This index is constructed based on rolling daily 5% of the front-month contract to the second-month contract. This means the index always has one month to expiry. It also means that daily rolling averages out the rolling yield for any given month.  The rule is simple: invest in the short-term volatility futures only when the VIX is outside its normal range. Since its inception in 1990, the VIX average is about 20. To test how different thresholds and rebalancing frequencies work, we test four different VIX thresholds: 25, 30, 35 and 40 with both weekly and monthly rebalances. The rebalance rule is: if the VIX is greater than a threshold at the end of one period, then in the next period, 5% of the fund is allocated to the S&P short-term VIX futures index and 95% is allocated to MSCI US. Otherwise 100% goes to MSCI US equities. For comparison, we also run a static hedge that has 5% in VIX futures and 95% in the MSCI US index.  The monthly rebalanced results are quite interesting, as shown in Table 3 and Chart 7: Table 3Dynamic Hedging Using VIX Futures Chart 7Dynamic Hedging Works Despite a terrible risk-return profile on its own, VIX futures can be a good risk mitigator when the hedge is put on only when the VIX is above a certain threshold.  Even though the 60-40 wins in terms of risk-adjusted return, dynamically hedged portfolios have better returns than both the 60-40 and US equities. The results are also robust when we do a weekly rebalance. Three conclusions can be drawn from Charts 8A and 8B, and Chart 9: Chart 8ADynamic Hedging – Monthly Rebalance Chart 8BDynamic Hedging – Weekly Rebalance     Chart 9Simple But Robust Dynamic Hedging   Hedging reduces volatility significantly. The lower the VIX threshold is, the larger the volatility reduction in the hedged portfolio compared to the unhedged. Hedging also improves average returns, albeit at a smaller scale compared to the reductions in volatility. Depending on the rebalancing frequency, the return improvement differs. For the monthly rebalance, the best VIX threshold lies between 30-35; for the weekly rebalance, the best is when the VIX threshold is at 30. Hedging is not needed all the time because volatility is within a normal range most of the time. Even when it spikes, it does not stay high for an extended period of time. Bottom Line: A simple rule-based dynamic hedging approach using VIX futures can substantially improve an equity portfolio’s risk-return profile by decreasing volatility significantly without sacrificing return. In a low interest rate environment, dynamic hedging using VIX futures can be a good alternative to a 60-40 equity-bond mix.   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com   Footnotes 1  https://www.institutionalinvestor.com/article/b1l65mvpw5xpts/The-Inside-Story-of-CalPERS-Untimely-Tail-Hedge-Unwind 2 https://www.institutionalinvestor.com/article/b1l9c8n9lgdj1r/AIMCo-s-3-Billion-Volatility-Trading-Blunder 3 https://www.bloomberg.com/news/articles/2020-04-08/taleb-advised-universa-tail-risk-fund-returned-3-600-in-march 4 https://www.universa.net/UniversaResearch_SafeHavenPart1_RiskMitigation.pdf 5  https://www.universa.net/UniversaResearch_SafeHavenPart1_RiskMitigation.pdf 6 https://www.universa.net/UniversaResearch_SafeHavenPart2_NotAllRisk.pdf 7 https://www.bloomberg.com/news/articles/2020-04-08/taleb-advised-universa-tail-risk-fund-returned-3-600-in-march 8  https://en.wikipedia.org/wiki/Variance_swap 9 https://www.eurekahedge.com/Indices/CBOE-Eurekahedge-Volatility-Indexes-Methodology  

Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil   Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1  In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices   Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Chart I-7Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Chart I-9FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable   Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher.  All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High     In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation.   For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities   Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com      1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.

Highlights Duration: Investors should keep portfolio duration close to benchmark, but continue to hold yield curve steepeners (on both the nominal and real yield curves) as well as overweight TIPS positions versus nominal Treasuries. These tactical trades will profit from higher Treasury yields in the near-term. Healthcare: We recommend an overweight allocation to investment grade Healthcare bonds relative to the overall investment grade corporate index. But we also recommend an underweight allocation to high-yield Healthcare relative to the high-yield corporate index.  Pharmaceuticals: Investors should underweight Pharmaceutical bonds in both the investment grade and high-yield credit universes. How Much Higher For Bond Yields? Two weeks ago, we warned that bonds would struggle in the near-term as the re-opening of the US economy led to an improvement in economic data.1 However, we definitely didn’t anticipate the magnitude of the positive data surprise that has occurred since then. The US Economic Surprise Index was -55 one week ago and today it sits at +66 (Chart 1)! The bulk of that jump occurred after Friday’s employment report revealed that 2.5 million jobs were added in May when Bloomberg’s consensus estimate had called for a contraction of 7.5 million. Against this back-drop, it shouldn’t be too surprising that bond yields jumped sharply. The 30-year Treasury yield rose 27 bps last week to 1.68% and the 10-year yield rose 26 bps to 0.91% (Chart 2). The 2-year yield rose a more modest 6 bps to 0.22%, as the Fed maintains its tight grip on the front-end of the curve. Chart 1Back In Business Chart 2Yields Have Room To Move Higher For investors, the first relevant question is: How high can yields go? Our view is that if last week does indeed represent the cyclical economic trough, then forward rates at the long-end of the curve will revert to levels consistent with market expectations for the long-run neutral fed funds rate. The median estimate of that rate from the New York Fed’s most recent Survey of Market Participants is 2%, but with an unusually wide interquartile range of 1.3% to 2.5% (Chart 2, bottom panel). At the very least, we’d expect the 10-year and 30-year Treasury yields to re-test their respective 200-day moving averages of 1.38% and 1.91%, respectively. However, we are not ready to declare last week the economic trough for three reasons: First, we cannot rule out a re-acceleration in the number of confirmed COVID cases as the economy re-opens. This could lead to the re-imposition of lockdown measures come fall. Second, last week’s positive economic data might cause some members of Congress to question the need for further fiscal stimulus. This would be a mistake. In last week’s report we showed that fiscal measures have done a good job propping up household income so far, but these measures are temporary and will need to be renewed.2  Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak (Chart 1, bottom panel). This is by no means a fully healed economy that can withstand policymakers taking their feet off the gas. Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak. Finally, US political risks are heightened with anti-police protests occurring daily in most major cities. Added to that, President Trump is now the underdog heading into November’s election and he will need to develop a reelection bid that doesn’t hinge on the economy. Our geopolitical strategists think a doubling down on “America First” foreign and trade policies makes the most sense.3 A significant move in that direction would certainly send a flight to quality into US bonds. Investment Strategy As we advised two weeks ago, nimble investors should tactically reduce duration as yields still have more upside in the next month or two. However, we are not yet sufficiently confident in the sustainability of the economic rebound to recommend reducing portfolio duration on a 6-12 month horizon. Rather, we continue to recommend keeping portfolio duration close to benchmark while holding several less risky positions that will profit from higher yields. Specifically, investors should hold duration-neutral curve steepeners along the nominal Treasury curve. We advise going long the 5-year note and short a 2/10 barbell.4 We also like holding TIPS over nominal Treasuries and positioning for a steeper real Treasury curve.5 In terms of spread product, we also recommend staying the course. This entails overweighting corporate bonds rated Ba and higher, Aaa consumer ABS, Aaa CMBS (both agency and non-agency) and municipal bonds, while avoiding corporate bonds rated B and below and residential mortgage-backed securities. Appendix A at the end of this report shows how these positions have performed since the March 23 peak in spreads. The remainder of this report focuses on the Healthcare and Pharmaceutical sectors of both the investment grade and high-yield corporate bond markets. Investment Grade Healthcare & Pharma Risk Profile When assessing the risk profiles for investment grade-rated Healthcare and Pharmaceutical bonds, we first consider the credit rating distributions of both sectors relative to the overall Bloomberg Barclays corporate index (Chart 3). Chart 3Investment Grade Credit Rating Distribution* Immediately, we see that the Healthcare sector has a lower credit rating than the benchmark: 71% of the Healthcare index is rated Baa, compared to 48% for the corporate index. Meanwhile, the Pharmaceuticals sector has slightly higher credit quality than the corporate benchmark: 12% of the Pharmaceuticals index is rated Aa or Aaa, compared to 8% for the corporate index. Credit rating alone suggests that Healthcare should trade cyclically relative to the corporate index. That is, it should outperform during periods of spread tightening and underperform during periods of spread widening. However, this turns out to not be the case. Chart 4 shows that healthcare has outperformed the corporate benchmark during each of the last five major bouts of spread widening and underperformed during periods of spread tightening. Clearly, despite its low credit rating, Healthcare trades like a defensive corporate bond sector. Healthcare’s historically defensive nature is confirmed by its duration-times-spread (DTS) ratio, which has tended to be below 1.0 (Chart 4, top panel).6 Though recently, the DTS ratio climbed above 1.0 due to a lengthening of the sector’s duration (Chart 4, bottom panel). This suggests that Healthcare, while historically defensive, might trade more cyclically during the next 12 months. Neither the Healthcare nor Pharmaceuticals sectors offer a spread advantage over the corporate index. Pharmaceuticals, on the other hand, are a much more cut and dry defensive sector (Chart 5). The DTS ratio is almost always below 1.0 and the sector has a strong track record of outperforming the corporate index during periods of spread widening (Chart 5, panels 2 & 3) Chart 4IG Healthcare Risk Profile Chart 5IG Pharma Risk Profile   Valuation Turning to valuation, we find that neither sector offers a spread advantage compared to the corporate index or its comparable credit tier (Table 1). This is true whether we look at the raw option-adjusted spread or if we control for duration differences by looking at the 12-month breakeven spread.7  It is interesting to note that the Healthcare index offers a spread advantage compared to the A-rated corporate index. On the one hand, this is not surprising because the Healthcare index carries an average Baa rating. On the other hand, we have seen that Healthcare tends to trade more defensively than its average credit rating implies. This arguably makes its spread advantage over A-rated debt somewhat compelling. Table 1IG Healthcare & Pharma Valuation Balance Sheet Health Both the Healthcare and Pharmaceuticals sectors loaded up on debt during the last recovery. The amount of Healthcare debt in the corporate index grew 8.8 times since 2010. Meanwhile, total debt in the corporate index grew 2.4 times. The result is that Healthcare’s weight in the corporate index increased from 1.1% in 2010 to 4.3% today (Chart 6). The Pharma sector also increased its debt load at a faster pace than the overall corporate universe since 2010 (3.2 times versus 2.4 times), but the boom in Pharma debt has been much milder than in Healthcare. The weight of Pharmaceuticals in the corporate index increased from 4.1% in 2010 to 5.5% today (Chart 7). Chart 6IG Healthcare Debt Growth Chart 7IG Pharma Debt Growth Despite rapid debt growth during the past few years, credit quality in both the Healthcare and Pharma sectors appears quite solid. Appendix B lists the issuers in the Healthcare index, grouping them by credit tier and indicating whether they carry a positive, stable or negative ratings outlook from Moody’s. Of the 56 issuers in the Healthcare index, only six currently have a negative ratings outlook. The two largest issuers in the Healthcare index are Cigna and CVS Health. Both carry Baa ratings, but Moody’s just confirmed Cigna’s ratings outlook at stable in mid-May. CVS Health, on the other hand, has carried a negative ratings outlook since 2018. Appendix C lists issuers in the Pharmaceuticals index. Of the 17 issuers, only four carry a negative ratings outlook. None of the Baa-rated Pharmaceutical issuers currently has a negative ratings outlook. The two biggest issuers in the index are Bristol-Myers Squibb and Abbvie. Bristol-Myers Squibb is A-rated with a negative outlook, while Abbvie is Baa-rated with a stable outlook. Macro Considerations In a typical demand-driven recession, consumers tend to prioritize healthcare spending while they cut back on more discretionary outlays. This dynamic is probably what causes healthcare bonds to trade defensively relative to the overall corporate index. However, the unique nature of the COVID recession has thrown this traditional pattern into reverse. Consumer spending on health care services is down 40% since February while overall consumer spending is 19% lower (Chart 8). Oddly, healthcare bonds shrugged off this year’s massive drop in spending and continued to behave defensively – outperforming the corporate index when spreads widened and underperforming since the March 23 peak in spreads. Despite the plunge in spending, pricing power in the health care industry remains strong. Health care services prices continue to accelerate even as overall inflation has dropped sharply (Chart 8, bottom panel). Unlike healthcare, pharmaceutical spending has held firm during the past couple of months (Chart 9). Consumer spending on pharmaceuticals is only down 4% since February, while overall consumer spending is down 19%. But despite firm spending, medicinal drug prices have decelerated in concert with the overall headline CPI (Chart 9, bottom panel). Chart 8Healthcare Demand & Pricing Power Chart 9Pharmaceutical Demand & Pricing Power Investment Conclusions Putting everything together, we are inclined to recommend an underweight allocation to Pharmaceuticals and an overweight allocation to investment grade Healthcare. Pharmaceuticals are simply too expensive and too defensive for the current environment. Given our positive outlook on investment grade corporate bonds, we should target cyclical sectors with elevated spreads that have more room to compress. Healthcare is slightly more interesting. It has behaved like a typical defensive sector so far this year, but there are some indications that it is becoming more cyclical. The DTS ratio recently shot above 1.0 and consumer spending on healthcare services is poised for a rapid snapback. In terms of valuation, healthcare is expensive relative to other Baa-rated bonds but cheap versus the A-rated universe. This would seem to make healthcare a good risk-adjusted bet. Even if the sector continues to behave defensively, its spread advantage over A-rated bonds makes it an attractively priced defensive sector. High-Yield Healthcare & Pharma Risk Profile Considering the risk profile of high-yield Healthcare and Pharmaceuticals, we first notice that both sectors have significantly lower credit ratings than the overall junk index (Chart 10). Ba-rated credits account for 29% and 24% of the Healthcare and Pharma indexes, respectively, compared to 54% for the High-Yield index as a whole. Chart 10High-Yield Credit Rating Distribution* The fact that significant portions of the Healthcare and Pharmaceutical indexes are rated B and lower immediately raises alarm bells. This is because we do not expect that many B-rated or lower issuers will be able to take advantage of the Fed’s Main Street Lending Program. This lack of Fed support for the lower-rated junk tiers has led us to recommend underweighting junk bonds rated B & below.8 High-yield Healthcare and Pharmaceuticals sectors have significantly lower credit ratings than the overall junk index. Interestingly, despite low credit ratings, a look at both sectors’ DTS ratios and historical excess returns reveals that they tend to trade defensively relative to the high-yield benchmark index. Healthcare outperformed the high-yield index by 473 bps from the beginning of the year until the March 23 peak in spreads and has underperformed the index by 123 bps since (Chart 11). Similarly, Pharmaceuticals outperformed the junk index by 670 bps from the beginning of the year until March 23 and have since underperformed by 136 bps (Chart 12). Chart 11HY Healthcare Risk Profile Chart 12HY Pharma Risk Profile Valuation Turning to spreads, we would characterize both high-yield Healthcare and Pharmaceuticals as expensive (Table 2). Despite both sectors carrying average credit ratings of B, they offer spreads that are below both the overall junk index average and the average for other B-rated credits. Tight option-adjusted spreads are at least partially attributable to low average duration for both sectors. If we adjust for duration differences by looking at 12-month breakeven spreads, we see that Pharmaceuticals look somewhat cheap versus other B-rated credits while Healthcare remains expensive. Table 2HY Healthcare & Pharma Valuation Balance Sheet Health Healthcare debt has grown less quickly than overall high-yield index debt since 2010 (Chart 13). Healthcare debt has grown 1.7 times since 2010 while the overall index has grown 1.8 times. This has caused Healthcare’s weight in the index to fall from 6.2% to 5.7%. In contrast, the high-yield Pharmaceuticals sector has grown rapidly during the past decade (Chart 14). Pharma debt has increased 10.3 times since 2010 compared to 1.8 times for the overall index. This has brought the sector’s weight in the index up to 2.3% from 0.4% Chart 13HY Healthcare Debt Growth Chart 14HY Pharma Debt Growth Looking beyond debt growth, in the current environment we are mostly concerned with the number of issuers in each index that will be able to access Fed support through the Main Street Lending facilities. In this regard, neither sector fares particularly well. Appendix D lists all high-yield Healthcare issuers along with their ratings outlooks, number of employees, 2019 revenues and total debt-to-EBITDA ratios. To qualify for the Fed’s Main Street Lending facilities, issuers must have either less than 15000 employees or less than $5 billion in 2019 revenues. Additionally, they must be able to keep their Debt-to-EBITDA ratios below 6.0. We estimate that all but three of the Ba-rated Healthcare issuers are eligible for the Main Street program, but only one of the B-rated issuers is eligible. High-yield Pharmaceuticals issuers are listed in Appendix E. Here, we once again find that only one of the B-rated issuers is likely to qualify for the Main Street lending facilities. Of the two Ba-rated issuers, one is likely to qualify. The other is Bausch Health, a Canadian firm that is by far the largest issuer in the Pharma index. It would need to turn to the Canadian authorities for help in an emergency lending situation. Investment Conclusions We recommend underweight allocations to both the high-yield Healthcare and Pharmaceuticals sectors. In the current environment we prefer to focus our high-yield credit exposure on the Ba-rated credit tier where issuers are more likely to have access to Fed support. The large concentration of B-rated and lower issuers in both the Healthcare and Pharma sectors, along with their generally expensive valuations, makes us wary about both sectors. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B Table 4Investment Grade Healthcare Issuers Appendix C Table 5Investment Grade Pharmaceuticals Issuers Appendix D Table 6High-Yield Healthcare Issuers Appendix E Table 7High-Yield Pharmaceuticals Issuers   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Portfolio Allocation Summary, “Filling The Income Gap”, dated June 2, 2020, available at usbs.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, “Spheres Of Influence (GeoRisk Update)”, dated May 29, 2020, available at gps.bcaresearch.com 4 For more details on this recommended yield curve position please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on these recommendations please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 6 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 7 The 12-month breakeven spread represents the spread widening that must occur for a sector to underperform a duration-matched position in Treasury securities during the next 12 months. It can be proxied by option-adjusted spread divided by duration. 8 For more details please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear client, Along with an abbreviated report this week we are sending you this Geopolitical Strategy service report written by my colleague Matt Gertken, BCA’s Geopolitical Strategist. Matt argues that US social unrest is structural and therefore can still cause volatility, while the market’s recognition that Trump is an underdog is also a risk. I hope you will find this report both interesting and informative. Kind Regards, Anastasios   Portfolio Strategy While we remain constructive on the prospects in the broad equity market over the coming 9-12 month time horizon, a flare up in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities. Recent Changes Last week our rolling stop was triggered and we downgraded the S&P biotech index to neutral and booked gains of 5% since inception.1 Table 1 The SPX catapulted to fresh recovery highs last week, on the back of optimism surrounding the successful reopening of the economy along with the ongoing support of easy fiscal and monetary policies. Sentiment is not as extended as in February or during previous SPX tops in the past few years, as we highlighted in recent research.2 However, greed is slowly showing up on our radar screens as investors that have missed out on the rally are chasing performance. Additionally, the market action has an element of a short squeeze. Equity market internals signal that there is likely a bit more gas left in the tank, despite the roughly 1000 point rise since the March 23 lows. While the S&P transports index has neither made new all-time highs nor outperformed the SPX year-to-date, one economically hypersensitive sub-group, trucking, has been revving its engines. The S&P 1500 trucking index has stealthily joined the “new all-time highs” club. The highly fragmented trucking industry has an excellent track record in leading the S&P 500 and the current message is that the path of least resistance remains higher for the SPX (Chart 1). As large parts of the economy are reopening, this index seems to have priced in a full recovery and a return to normal in the back half of the year. The jury is still out on the economic recovery’s shape and the risk of a second viral wave is significant, but stocks continue to climb the proverbial "wall of worry". Chart 1Trucking As A Leading Indicator Importantly, another extremely pro-cyclical equity market indicator, the S&P deep cyclicals/defensives share price ratio, has also led the broad equity market bottom and continues to herald additional gains for the SPX (Chart 2). Deep cyclicals include tech stocks, but even if IT were excluded, the cyclicals ex-tech/defensives ratio still troughed prior to the SPX and is gaining steam. Chart 3 shows the GICS1 sector returns since the March lows and technology is similar to the overall market’s return. The deep cyclical trio (energy, industrials and materials) have outperformed the tech sector, and bested defensives by a wide margin. Chart 2Cyclicals Are Besting Defensives Chart 3GICS1 Sector (%) Returns Since The March Lows Our Global Trade Activity Indicator corroborates the message that the cyclicals/defensives ratio is emitting (Chart 4). The recent breakout in the JPM EM currency index along with budding evidence of China’s economic recovery and likelihood of a stimulus package (not as large as the GFC, but bigger than the early-2016 manufacturing recession one) suggest that global growth is slated to recover in the back half of the year. Chart 4Looming Global Growth Recovery Nevertheless, it is quite unnerving that the SPX has broken out to fresh recovery highs despite bleak economic fundamentals and rising political and geopolitical risks. One potential negative catalyst that could cause a healthy reset is the rise in the polls of Democratic presidential candidate Joe Biden ahead of the November elections. Chart 5 shows that over the past year, the S&P 500 has moved in lockstep with the relative odds of a Republican versus a Democrat getting elected President. But recently, a wide gap has opened warning that the SPX is vulnerable to a pullback. In truth, the online gambling community has been slow to react to the erosion of President Trump’s platform due to pandemic and recession – so his odds could fall further in the near term. At the margin, a Biden win should be negative for the stock market because his party is perceived as more hostile to businesses and the specter of higher taxes could trip up the SPX. Our Geopolitical Strategy service has highlighted this risk in recent reports, including on May 15.3 Tack on the persistently high reading in the Baker, Bloom and Davis Policy Uncertainty Index and the risk/reward tradeoff for the overall market tilts further to the downside at the current juncture (Chart 6). Chart 5Do Not Neglect (Geo)Political Risks Chart 6High Policy Uncertainty Is A Red Flag Bottom Line: While we remain constructive on the SPX over the coming 9-12 month time horizon, a flare up in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Geopolitical Strategy Social Unrest Can Still Cause Volatility Highlights Social unrest in the US is driven by structural and cyclical factors as well as election-year opportunism. It can still cause volatility. Unrest will weigh on consumer and business confidence – adding to already ugly fundamentals. The market has come around to our view that Trump is an underdog in the election. This is a risk to equities since a Democratic victory will bring full control of government. President Trump has low legal or political constraints to deploying the military if violence gets worse in the streets. This increases tail risks of a civilian death that amplifies the unrest. A “silent majority” of voters could give Trump a polling boost as a “law and order” candidate later this year. This could require us to upgrade his odds of reelection. The US dollar faces long-term headwinds but we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. Feature Chart 1Markets Skyrocket On Stimulus & Reopening Economic reopening and stimulus are winning the day as investors continue to look forward to a time when growth and corporate earnings recover yet inflation and risk-free rates remain suppressed. Judging by the breakout of cyclical versus defensive stocks and risk-on versus risk-off currencies, the rally could continue and the gap between stock markets and macro fundamentals could widen further for some time (Chart 1). The market is looking through the most widespread social unrest since 1968 in the United States, which emerged due to the death in police custody of a black man, George Floyd, in Minneapolis. History suggests that over a one-year horizon, social unrest can be ignored – but in the near term it could yet provoke volatility. This risk is underrated because the market already believes that the unrest is a known quantity without material impact, yet this report shows otherwise. We see four new risks, the first three negative for the market. Chart 2US Consumer Sentiment Is Vulnerable Consumer confidence and activity could worsen in the face of historic national unrest. The slight uptick in improving consumer expectations could reverse (Chart 2). President Trump’s odds of reelection could fall permanently, triggering a downgrading of long-run earnings expectations. A mistake could cause unrest to reach an unknown critical threshold that strikes fear into investors about US stability. The US debate has moved on from racism to “fascism” as Trump’s opponents criticize him for his authoritarian rhetoric and deployment of military forces to secure parts of Washington, DC. Structural factors are driving the riots which means they may smolder and additional incidents could cause them to flare up throughout summer and fall. The deployment of troops to quell civil unrest – as in any country at any time – could easily lead to bloody mistakes. The upside risk is that Republican senators will capitulate even sooner on fiscal spending measures, seeing that their corporate power base is likely to feel more concerned about the collapse of society. The House Democrats and President Trump already share an interest in larding up the spending, so it was only a matter of time till the senate caved in anyway. If the next $2 trillion arrives without the June-July hiccup that we expect, then the market could power higher (Chart 3). Chart 3Global Fiscal Stimulus Continues To Grow In this report we show why US social unrest is structural and how it can still bring equity volatility. Also, the online betting market has caught up to our view that Trump is the underdog in the election. The prospect of full Democratic Party control could start to weigh on US equities. The upside risk to this view would be markets cheer Biden – which is unlikely for long – or if the violent protests create a “silent majority” that helps Trump win the swing states. If his polling improves in the wake of the riots – and the stock rally continues unabated – then we may upgrade his reelection odds from 35% to 50% or higher. Bottom Line: A pullback would be a buying opportunity, but a 10% correction could easily transpire given that a falling market reduces Trump’s odds greatly and could kill the market’s faith in Trump reflation policy from 2021-24. How Social Unrest Came To The United States The US was ripe for a major bout of unrest, as we have highlighted in past reports such as “Populism Blues” (2017), “Civil War Lite” (2019), and “Peak Polarization” (2020), as well as in our top five “Black Swans” report for this year. Our updated “Great Gatsby Curve” shows countries with high levels of income inequality and social immobility. The US is right in the danger zone, joined by other countries that have had unrest or political disruptions (Argentina, Chile, UK, Italy) or will soon (China) (Chart 4). African Americans suffer the worst of these ills and also have long-running grievances with the criminal justice system. Chart 4The US Is In The Danger Zone For Populism, Unrest Unrest was an easy prediction even before the pandemic and recession, which made matters worse. The US ranks last, among developed markets, just below Greece, in our COVID-19 Unrest Index (Table 1). This index combines four factors – economic fundamentals, vulnerability to COVID-19, household grievances, and governance indicators – to rank countries according to their susceptibility to social unrest. US unemployment has soared higher than that of other countries as it has less generous automatic stabilizers. Table 1US Ranks Worst In Our COVID-19 Social Unrest Rankings When it comes to the virus, the US is not any harder hit than most of its European peers (Chart 5). And the black community is not much harder hit than whites, although both have suffered more than their population share would imply, and more than the Hispanic community (Chart 6). Chart 5US No Different Than Western Europe On COVID-19 Deaths   Chart 6COVID-19 Least Deadly For Hispanics However, the lockdowns have caused the unemployment rate to soar and exacted a greater toll on the least educated and lowest paid members of society. The election is enflaming the situation. President Trump’s economy has now performed little better for households than President Obama’s economy, assuming they suffer an income and wealth shock at least equal to that of 2008-09 (Chart 7). Chart 7Households Suffer Massive Income Shock Given the collapsing economy, Trump is doubling down on “law and order,” taking an aggressive stance against rioting and looting and thus provoking a backlash. The media is also in a feeding frenzy as the pandemic and economic reopening narratives lose traction and yet Trump perseveres. Polarization is intensifying as a result. Trump’s rhetoric has been egregious as always. His threat to invoke the Insurrection Act of 1807 is not. President George Bush Sr invoked the act to suppress the LA riots in 1992. The act’s provisions, as well as the specific exceptions to the posse comitatus laws and norms, give the president broad discretion in matters precisely like these. The real constraint is not legal but political: any popular backlash from Trump and his advisers in trying to “dominate the battlespace” when it comes to civilians at home. Rioting and looting are also unpopular, so a larger crackdown could easily happen if more unrest takes place. Since the riots are driven by structural factors, they could still escalate, especially if another incident of police brutality occurs. Bottom Line: US unrest is driven by structural and cyclical factors and thus we are in for another “long, hot summer” like 1967. Negative surprises should be expected. The larger risks have to do with the impact on the election and sentiment. Trump’s Polling Was Dropping Even Before The Riots Trump’s approval rating has fallen to the lowest level this year and diverged from the historic average (Chart 8). This increases the risk that the market experiences volatility either in expectation of “regime change” in November or in reaction to Trump’s attempts to regain the initiative. Trump’s deviation from President Obama’s approval at this stage in 2012 is a warning sign (Chart 9). Chart 8Trump’s Polling Drops Below Average Chart 9Trump Falls Off Obama’s Pathway To Reelection Chart 10Trump’s Pandemic Bounce Turns Negative, Unlike Others Trump and the Republican Party received a smaller polling bounce from the pandemic – and year-to-date the bounce is not only gone but has turned negative, comparable only to Vladimir Putin and United Russia (Chart 10). At its peak it was smaller than that of previous US presidents in crisis situations (Table 2, see Appendix). These data come from before the George Floyd incident which will make matters worse for Trump, given that initial polls suggest 35% approve and 52% disapprove of his response to it. The presumptive Democratic nominee Joe Biden is narrowly leading in all major swing states (Chart 11A). Trump has dropped off in critical swing states of Florida, Wisconsin, and Arizona (Chart 11B). Biden is closer to Trump than he should be in states like Ohio and even Texas. Chart 11ATrump Trailing Biden In Swing States Chart 11BTrump Loses Critical Support In FL, WI, AZ Chart 12Biden Polling Better Than Clinton Did Against Trump Biden is tentatively outperforming Hillary Clinton’s showing in 2016 in head-to-head polls against Trump, including in swing states (Chart 12). He has not been on voters’ minds much during the crises. But he has strong support among African American voters, who primarily handed him the party’s nomination, so he may be able to exploit the unrest. Voters indicate they favor him on race relations as well as the coronavirus, though they still favor Trump on the economy. Bottom Line: Trump’s polling was deteriorating before the social unrest. It will suffer more in the near term. But there are still five months until the election. The Market Now Recognizes That Trump Is An Underdog Now, with the country’s biggest cities ablaze, the market is waking up to the fact that Trump and the Republicans have a much greater chance of entirely losing control of the government in just five months. Online gamblers have recently upgraded Biden and the Democrats substantially (Chart 13). Opinion polling has shown weakness but now it is likely to seep into the financial industry’s consciousness that US domestic political risks could still go higher. Policy uncertainty will not fall as sharply as otherwise expected during the economic reopening. Unrest typically reflects negatively on the ruling party, suggesting the status quo is unacceptable and driving voters to vote for change. This is one of the 13 keys to the presidency under the scheme of Professor Allan J. Lichtman, at American University, who has predicted every popular vote outcome since 1984. If one accepts this thesis, then at least five of the keys have now turned against Trump and the GOP. If the economy somehow continues to shrink in the third quarter, or if GDP per capita falls harder than estimated in Chart 7 above, Lichtman’s model will turn against Trump (Table 3, see Appendix). Our own argument has been that a health crisis and surge in unemployment alone are enough to undercut him given his thin margins of victory four years ago and low approval rating. The George Floyd incident reinforces this logic. Not only is voter turnout correlated with the change in unemployment over the president’s term in office, but the correlation holds in swing states and among African Americans. Here is where the devastating impact of COVID-19 among blacks may be relevant (Chart 14). Chart 13Online Bookies Now See Trump Is Underdog Chart 14Hardship For Blacks In Swing States Chart 15Unemployment Pushes Up Voter Turnout (For Blacks And All) If the pandemic and unemployment did not already provide sufficient motivation, then the George Floyd incident might rally this core Democratic Party constituency to turn up at the ballot box (Chart 15). That is a threat to President Trump given that Barack Obama is not on the ballot, so black turnout is unlikely to reach 2008 or 2012 levels. Bottom Line: An increase in African American voter turnout due to unemployment and poor race relations would broaden the electoral pathway to a Democratic victory in November. A Risk To The View: The Silent Majority Could the unrest help Trump? Possibly. Once the peaceful protests turned violent, the possibility emerged that Trump could benefit. The Democrats are not in a strong position whenever they link themselves to economic lockdowns and rioting and looting. It is clear from the police killings and unrest of 2014-15 that more and more people have lost confidence in police treating blacks and whites equally (Chart 16), but they do not make up a majority. Chart 16Over Time, Voters Losing Confidence In Police Fairness Chart 17Majority Sees Racism As Individual, Not Institutional Moreover, two-thirds of citizens, two-thirds of Hispanics, and almost half of blacks believed at that time that racism and discrimination stem from individual actions rather than institutional factors (Chart 17). Confidence and institutional trust will fall during today’s crisis moments but the above polls suggest limits to the protest movement. Generally Americans are satisfied with the work of their local police departments (Chart 18). This includes 72% of blacks. Only about a quarter of Americans report being harassed by the police at any time, according to a Monmouth University poll. Chart 18Silent Majority? Most Americans Satisfied With Local Police Almost 80% of people believe police funds should be increased or kept the same, versus 21% who agree with defunding the police. Only 39% of blacks support such a proposal (Chart 19). If House Democrats pass legislation characterized as taking funds away from police it will hurt them. Chart 19Silent Majority? Americans Don’t Want To Cut Police Funding Finally, regarding the use of the military, 58% of Americans approve of the US military supplementing city police forces, while 30% oppose (Chart 20). George Bush Sr deployed troops in a similar predicament, the LA riots of 1992, albeit with an invitation from the California governor. Chart 20Silent Majority? Americans Mostly Support Military Aid To Police Amid Unrest Legal constraints on Trump’s use of the military are low. Given that the political constraint is also low, a resurgence in violence will likely lead to a crackdown. Trump could benefit if it is managed successfully, but the risk of a bloody mistake that harms or kills civilians would also go up. Bottom Line: Trump could benefit from his pitch as the candidate of law and order if unrest continues, violence worsens, and his actions are deemed to restore order. We will upgrade Trump’s reelection odds if his polling improves and the stock market and economy continue to rebound. Investment Takeaways Historic bouts of unrest show that market volatility occurred in the wake of the 1965-69 disturbances, the 1992 LA riots, the breakdown of order in New Orleans after Hurricane Katrina in 2005, and the protests and riots against police brutality in 2014-15. Unrest did not prevent the market from rallying in all of these cases, but it did in some, and pullbacks also followed unrest periods. In every case presidential approval suffered – and in 1968, 1992, 2006, and 2014 the ruling party suffered losses in the election (Charts 21 A-D). Chart 21AThe ‘Long, Hot Summer’ Saw Inflation, Volatility Chart 21BLA Riots Saw Unemployment, Volatility Chart 21CKatrina Saw Volatility, Presidential Approval Drop Chart 21DFerguson Saw Volatility Amid Falling Unemployment Chart 22Confidence Suffers Amid Social Unrest Furthermore, consumer and business confidence generally suffered in these periods (Chart 22). Trump’s reelection bid could fail to recover, which would make him a lame duck and heighten political risks dramatically. Our longstanding view that the party that wins the White House will also win the senate is reinforced by this year’s polls. The market is reacting to stimulus now but policies look to turn a lot tougher on business. The election puts a self-limiting factor into the equity rally. Either the market sells off in the short run to register the currently likely victory of Joe Biden, who will hike taxes, wages, and regulation, or the market rallies all the way till the election, increasing the chances of President Trump’s reelection, which would revolutionize the global system, especially on trade, and would require a selloff around December. The US dollar faces near-term headwinds as global growth recovers and uncertainty related to COVID-19 abates, but the near term is murky, whereas the major headwinds are over a cyclical time horizon. Our theme of “peak polarization” in the US contrasts starkly with our theme of “European integration” and implies that the euro can continue to advance. However, we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. The risk of a Trump victory is still substantial and we view Europe as a marginal loser in that scenario. We still expect investors to flee to the dollar in the event of any global crisis, even if it originates in the United States.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Table 3Lichtman’s 13 Keys To The Presidency Likely Turning Against Trump … Economy Critical   Footnotes 1     Please see BCA US Equity Strategy Insight Report, “Housekeeping” dated June 4, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Weekly Report, “There’s No Limit” dated May 26, 2020, available at uses.bcaresearch.com. 3    Please see BCA Geopolitical Strategy Weekly Report, “Michelle, Amash, Trump, Biden” dated May 15, 2020, available at gps.bcaresearch.com

Highlights The dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds. The reason is that the economic landscape remains fraught with uncertainty, both politically and economically. We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and GBP along with some safe havens. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for dollar downside. The EUR/USD could touch 1.16, while still staying in the confines of a structural bear market. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Feature Chart I-1The Dollar Tries To Break Down The DXY index is punching below key support levels in an attempt to reverse the cyclical bull market in place since 2011. Our technical roadmap has been the upward-sloping channel, in place since 2018 (Chart I-1). At 96.77, the DXY index is already several ticks below the lower bound of this channel. As the breakdown becomes more broad based, especially vis-à-vis the euro, this will cement the transition from easing financial conditions to improving global growth. Cyclical currencies such as the Australian dollar and the Norwegian krone have already bounced powerfully from their March lows and have now entered the technical definition of a bull market (Chart I-2). For example, from a low of 55 cents, the Aussie is now trading at 69 cents, up 25%. As long-term dollar bears, our portfolio has benefited tremendously from this shift in market sentiment.1  Chart I-2A Report Card On Currency Performance The key question for new investors is whether the move in the dollar represents a false breakdown or the beginning of a cyclical bear market. To answer this, we are reviewing key charts and indicators to explain dollar weakness and help gauge whether it pays to enter new short positions. Explaining Dollar Weakness US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are reopening faster. As a result, economic momentum is higher outside the US. The rise in economic momentum is supporting money velocity outside the US. In other words, animal spirits are being rekindled at a faster pace abroad. In the classical equation MV=PQ,2 a rise in both M and V can be explosive for nominal output. Higher money velocity outside the US has started to attract capital inflows. This is beginning to show up in the outperformance of non-US markets. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace.  Chart I-3 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. This was exacerbated by a dollar liquidity shortage, as demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. As Chart I-2 illustrates, developed market currencies have fared in pecking order of the easing in lockdown measures, with the AUD outperforming the CAD, and the SEK outperforming the EUR. Prior to the onset of COVID-19, there was a pretty tight correlation between global services relative to manufacturing activity and the dollar (Chart I-4). As a relatively closed economy, the US tended to benefit when services output had the upper hand. This time around, the service sector has been hit much harder due to social distancing measures in place, but it is also likely to have a more drawn-out recovery. For example, visits to theme parks or restaurants are unlikely to retrace back to their pre-crisis peaks anytime soon. However, construction activity, especially geared towards infrastructure or residential housing, may bounce back sooner. Chart I-3A Strong Recovery Outside The US Chart I-4USD And Manufacturing Vs Services The key message is that global manufacturing activity so far is holding up better than services, and activity is picking up faster abroad. This has historically been good news for procyclical currencies. Money Velocity And The Dollar There is increasing evidence that money velocity is being supported outside the US. For global manufacturing activity to recover, it requires a rise in animal spirits to begin to capitalize on very generous financing conditions. In this respect, there is increasing evidence that money velocity is being supported outside the US. In the euro area, the velocity of money in Germany has stopped falling relative to the US. This is a marked change from anything we have seen since the European debt crisis. More importantly, the ebb and flow of ‘V’ in Germany relative to the US has mirrored the relative path of interest rates (Chart I-5). Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for the improvement in PMIs (Chart I-6). Granted, the improvement in relative V has been driven mostly by the collapse in US money velocity. But what matters for currencies are relative trends. Once economic activity enters a full-fledged recovery, we expect US output to be hampered by the rise in the dollar over the past 18 months, while cyclical economies will be buffeted by much-cheapened currencies. This raises the prospect of much more pronounced economic vigor outside the US. Chart I-5Money Velocity Support In Europe Chart I-6Euro Area Sentiment Is Improving The ratio of the velocity of money between the US and China has tended to track the gold/silver ratio (GSR) with a tight fit (Chart I-7). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the US. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses than gold. Therefore, the recent collapse in the GSR is prescient.   Soft data confirms this trend. Both the Caixin and NBS manufacturing PMI are outperforming that in the US, and are likely to keep doing so in the coming months (Chart I-8). Chart I-7Money Velocity Support In China? Chart I-8Wide Gap Between Chinese And US Output It is important to note that while there has been some disconnect between the performance of the economy and stock prices, no such dichotomy exists in currency markets. The ratio of cyclical currencies relative to defensive ones tends to track the global PMI directionally. While this ratio is below its 2008 lows, the global PMI has bottomed at higher levels (Chart I-9). The difference can probably be explained by the fact that either domestic investors (especially retail) have been the dominant buyers of equities, and/or institutional investors have been hedging currency risk. It is true that the bounce in AUD/CHF (or other procyclical pairs) from the lows has brought it closer to technically stretched levels, and some measure of indigestion is overdue. That said, this mainly reflects mean reversion from deeply oversold levels (Chart I-10). If manufacturing activity can keep improving, and the velocity of money outside the US can pick up, this will revive capital flows into these markets, which will lead to more pronounced breakouts. Given the huge uncertainty surrounding these forecasts, we believe the risk to the greenback is currently balanced. Chart I-9Equity And Currency Markets Have Diverged Chart I-10Still Oversold Capital Flows As An Indicator The nascent upturn in a few growth indicators is also coinciding with a positive signal from equity markets. Global cyclical stocks have started to outperform defensives in recent weeks, as flows into more cyclical ETF markets are accelerating (Chart I-11). Chart I-11Inflows Into Cyclical ETFs Chart I-12Inflows Into US Assets Are Picking Up The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Indeed, the latest data show that as recent as March, net foreign inflows into US equity markets were quite strong (Chart I-12). This might explain why the S&P 500 continued to outperform during the March drawdown. In a nutshell, the outperformance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to the euro area, commodity-producing countries, and other emerging and developed market currencies (Charts I-13A and I-13B). The catalyst will have to be rising relative returns on capital outside the US, but the starting point is also extremely attractive valuations. Chart I-13ANascent Bounce In Cyclicals Versus Defensives Chart I-13BNascent Bounce In Cyclicals Versus Defensives We recently penned a report titled “Cycles And The US Dollar,” which showed empirically that US valuations have more than fully capitalized future earning streams, especially vis-à-vis their G10 peers. That said, before a cyclical bear market can fully unfold, we are watching two key indicators for dollar downside: As the Fed continues to dilute existing bond shareholders, the ratio of the US bond ETF (TLT) to gold (GLD) will be an important proxy for investor sentiment. One of the functions of money is as a store of value, and gold remains a viable threat to the dollar (and Treasurys) in this regard. A falling ratio will suggest private investors are dumping their bond holdings in exchange for harder assets such as precious metals. Recent inflows into the GLD ETF may be signaling such a shift (Chart I-14), but it will take a clean break in this ratio below 0.95 to solidify the trend. As geopolitical tensions between US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, USD/CNY is holding close to cyclical highs, but a break above will put Asian currencies at risk. This will have negative implications for developed-market commodity currencies (Chart I-15). Chart I-14Gold And USD Inflows Diverge Chart I-15Tied To The Hip EUR, GBP 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. Being short the gold/silver ratio is also a good way to play an eventual economic recovery, with the benefit of a tremendous valuation cushion. The market certainly applauded the European Central Bank’s addition of €600 billion in bond purchases, given the fall in peripheral bond spreads. The euro also bounced on the back of two factors: Chart I-16QE And EUR/USD Even with additional stimulus, the balance sheet impulse of the Fed is still larger than that of the ECB (Chart I-16). Historically, this has favored long EUR/USD positions. The compression in peripheral spreads should boost European growth as it lowers the cost of capital for countries such as Spain and Italy. This improves debt dynamics and encourages the productive deployment of capital. Technically, the EUR/USD can rally towards 1.16 while remaining within the confines of a structural bear market (Chart I-17). Beyond this point, it will be imperative for European growth dynamics to take over the baton to support a much higher exchange rate. As we mentioned earlier, the velocity of money in Germany has stopped falling relative to the US, but relative improvement is not yet enough to warrant structural positions in EUR/USD. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Since the 1980s, this three-factor model has outperformed the DXY index by a significant margin (Chart I-18). Chart I-17EUR/USD Could Touch 1.16 Chart I-18The Model Is Short DXY In June Finally, our limit-sell on EUR/GBP was triggered at 0.90 last week. While valuation favors a short position, the ramp-up in Brexit tensions is a key risk to this trade. As such, we are placing tight stops at 0.905.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: Headline PCE fell from 1.3% to 0.5% year-on-year in April. Core PCE also declined from 1.7% to 1%. Personal income surged by 10.5% month-on-month in April, while personal spending decreased by 13.6%, implying a higher savings rate. Total vehicle sales increased from 8.6 million to 11 million in May. Factory orders fell by 13% month-on-month in April. The trade deficit widened from $42.3 billion to $49.4 billion in April. Initial jobless claims increased by 1877K for the week ended May 29th. The DXY index fell by 1.1% this week, reflecting cautiously positive sentiment as many countries started to ease lockdown measures.   Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020   The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Headline inflation fell from 0.3% to 0.1% year-on-year in May, while core inflation was unchanged at 0.9%. The unemployment rate increased from 7.1% to 7.3% in April. The Markit manufacturing PMI slightly fell from 39.5 to 39.4 in May, while the services PMI increased from 28.7 to 30.5. Retail sales plunged by 19.6% year-on-year in April, following an 8.8% decline the previous month. EUR/USD appreciated by 1.4% this week. On Thursday, the ECB kept key interest rates unchanged, while announcing a further 600 billion euros increase of its PEPP facility, taking the total to 1.35 trillion euros. There was also an extension of the program till 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   The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders plunged by 14.3% year-on-year in April. Housing starts fell by 12.9% year-on-year in April. Capital spending increased by 4.3% quarter-on-quarter in Q1. The monetary base surged by 3.9% year-on-year in May. The manufacturing PMI was unchanged at 38.4 in May, while the services PMI increased from 21.5 to 26.5. The Japanese yen fell by 1.3% against the US dollar this week. Japan lifted its nationwide state of emergency last week, however, the economy is still in deep recession as COVID-19 continues to disrupt global supply chains.   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 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The Markit manufacturing PMI slightly increased from 40.6 to 40.7 in May. The services PMI also ticked up from 27.8 to 29. Nationwide housing prices fell by 1.7% month-on-month in May. Money supply (M4) surged by 9.5% year-on-year in April. Mortgage approvals increased by 15.8K in April, down from 56K the previous month. GBP/USD increased by 1.7% this week. The Bank of England urged banks to step up no-deal Brexit plans this week, implying that there might have been a shift in the BoE’s assumptions about the outcome of ongoing talks between the UK and the European Union. That being said, we remain bullish on the pound from a valuation perspective, but are tightening our stop loss this week.   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 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The manufacturing index increased from 35.8 to 41.6 in May. The current account surplus increased from A$1 billion to A$8.4 billion in Q1. However, more recent trade data was less encouraging. Imports plunged by 9.8% month on month in April while exports slumped by 11.3%. The trade surplus narrowed from A$10.6 billion to A$8.8 billion. GDP grew by 1.4% year-on-year in Q1. On a quarterly basis, it fell by 0.3% compared with the last quarter in 2019.  Building permits increased by 5.7% year-on-year in April. AUD/USD appreciated remarkably by 4.5% this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. Moreover, the RBA sounds cautiously positive in its rate statement, saying that “it is possible that the depth of the downturn will be less than earlier expected.”   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 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Terms of trade fell by 0.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. It is the first fall since Q4 2018. Building permits fell by 6.5% month-on-month in April, following a 21.7% monthly decrease in March. NZD/USD increased by 4% this week. The fall in terms of trade was led by the decline in meat prices, including lamb and beef, from record levels at the end of 2019. Forestry product prices also fell by 3.4% quarterly in Q1. On a positive note, New Zealand is prepared to ease lockdown measures as there has been no new cases reported for nearly two weeks.   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 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: GDP plunged by 8.2% quarter-on-quarter in Q1. The Markit manufacturing PMI increased from 33 to 40.6 in May. Labor productivity increased by 3.4% quarterly in Q1. Imports fell from C$48 billion to C$36 billion in April. Exports also declined from C$46 billion to C$33 billion. The trade deficit widened from C$1.5 billion to C$3.3 billion.  The Canadian dollar rose by 2.2% this week, alongside oil prices. On Wednesday, the BoC kept interest rates unchanged at 0.25%. It also decided to scale back the frequency of some market operations as financing conditions have improved.   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 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell from 59.7 to 53.2 in May. Real retail sales plunged by 20% year-on-year in April, following a 5.8% decrease the previous month. The manufacturing PMI increased from 40.7 to 42.1 in May. GDP declined by 1.3% year-on-year in Q1. On a quarter-on-quarter basis, GDP fell by 2.6% compared with Q4 2019.  Headline consumer prices kept falling by 1.3% year-on-year in May. The Swiss franc rose by 0.5% against the US dollar this week. The 2.6% quarterly decline in Switzerland’s GDP has been the most severe since 1980, mostly led by hotels and restaurants which suffered a 23.4% fall. In addition, the consistent decline in consumer prices might lead the SNB to further step up FX intervention.   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 Chart II-18NOK Technicals 2 There has been scant data from Norway this week: The current account surplus increased from NOK 25 billion to NOK 66 billion in Q1. The Norwegian krone appreciated by 3.5% against the US dollar this week. Statistics Norway’s recent balance of payments report shows that the balance of goods and services surged to NOK 27 billion in Q1. Balance of income and current transfers also increased from NOK 1.9 billion to NOK 38.9 billion. Our Nordic basket against the euro and the US dollar is now 10% in the money.   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 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: GDP increased by 0.4% year-on-year in Q1, down from 0.5% the previous quarter. The trade surplus increased from SEK 5.2 billion to SEK 7.6 billion in April. The manufacturing PMI increased from 36.4 to 39.2 in May. Industrial production plunged by 16.6% year-on-year in April. Manufacturing new orders also declined by 20.7% year-on-year. The Swedish krona increased by 2.5% against the US dollar this week. Sweden’s GDP grew modestly in Q1, which is better than most of its European counterparts, following its decision not to impose a full lockdown to contain the virus.   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   Footnotes 1Please see our table of trades below. 2Where M = money supply, V = velocity of money, P = price level and Q = output.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Social unrest in the US is driven by structural and cyclical factors as well as election-year opportunism. It can still cause volatility. Unrest will weigh on consumer and business confidence – adding to already ugly fundamentals. The market has come around to our view that Trump is an underdog in the election. This is a risk to equities since a Democratic victory will bring full control of government. President Trump has low legal or political constraints to deploying the military if violence gets worse in the streets. This increases tail risks of a civilian death that amplifies the unrest. A “silent majority” of voters could give Trump a polling boost as a “law and order” candidate later this year. This could require us to upgrade his odds of reelection. The US dollar faces long-term headwinds but we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. Feature Chart 1Markets Skyrocket On Stimulus & Reopening Economic reopening and stimulus are winning the day as investors continue to look forward to a time when growth and corporate earnings recover yet inflation and risk-free rates remain suppressed. Judging by the breakout of cyclical versus defensive stocks and risk-on versus risk-off currencies, the rally could continue and the gap between stock markets and macro fundamentals could widen further for some time (Chart 1). The market is looking through the most widespread social unrest since 1968 in the United States, which emerged due to the death in police custody of a black man, George Floyd, in Minneapolis. History suggests that over a one-year horizon, social unrest can be ignored – but in the near term it could yet provoke volatility. This risk is underrated because the market already believes that the unrest is a known quantity without material impact, yet this report shows otherwise. We see four new risks, the first three negative for the market. Chart 2US Consumer Sentiment Is Vulnerable Consumer confidence and activity could worsen in the face of historic national unrest. The slight uptick in improving consumer expectations could reverse (Chart 2). President Trump’s odds of reelection could fall permanently, triggering a downgrading of long-run earnings expectations. A mistake could cause unrest to reach an unknown critical threshold that strikes fear into investors about US stability. The US debate has moved on from racism to “fascism” as Trump’s opponents criticize him for his authoritarian rhetoric and deployment of military forces to secure parts of Washington, DC. Structural factors are driving the riots which means they may smolder and additional incidents could cause them to flare up throughout summer and fall. The deployment of troops to quell civil unrest – as in any country at any time – could easily lead to bloody mistakes. The upside risk is that Republican senators will capitulate even sooner on fiscal spending measures, seeing that their corporate power base is likely to feel more concerned about the collapse of society. The House Democrats and President Trump already share an interest in larding up the spending, so it was only a matter of time till the senate caved in anyway. If the next $2 trillion arrives without the June-July hiccup that we expect, then the market could power higher (Chart 3). Chart 3Global Fiscal Stimulus Continues To Grow In this report we show why US social unrest is structural and how it can still bring equity volatility. Also, the online betting market has caught up to our view that Trump is the underdog in the election. The prospect of full Democratic Party control could start to weigh on US equities. The upside risk to this view would be markets cheer Biden – which is unlikely for long – or if the violent protests create a “silent majority” that helps Trump win the swing states. If his polling improves in the wake of the riots – and the stock rally continues unabated – then we may upgrade his reelection odds from 35% to 50% or higher. Bottom Line: A pullback would be a buying opportunity, but a 10% correction could easily transpire given that a falling market reduces Trump’s odds greatly and could kill the market’s faith in Trump reflation policy from 2021-24. How Social Unrest Came To The United States The US was ripe for a major bout of unrest, as we have highlighted in past reports such as “Populism Blues” (2017), “Civil War Lite” (2019), and “Peak Polarization” (2020), as well as in our top five “Black Swans” report for this year. Our updated “Great Gatsby Curve” shows countries with high levels of income inequality and social immobility. The US is right in the danger zone, joined by other countries that have had unrest or political disruptions (Argentina, Chile, UK, Italy) or will soon (China) (Chart 4). African Americans suffer the worst of these ills and also have long-running grievances with the criminal justice system. Chart 4The US Is In The Danger Zone For Populism, Unrest Unrest was an easy prediction even before the pandemic and recession, which made matters worse. The US ranks last, among developed markets, just below Greece, in our COVID-19 Unrest Index (Table 1). This index combines four factors – economic fundamentals, vulnerability to COVID-19, household grievances, and governance indicators – to rank countries according to their susceptibility to social unrest. US unemployment has soared higher than that of other countries as it has less generous automatic stabilizers. Table 1US Ranks Worst In Our COVID-19 Social Unrest Rankings When it comes to the virus, the US is not any harder hit than most of its European peers (Chart 5). And the black community is not much harder hit than whites, although both have suffered more than their population share would imply, and more than the Hispanic community (Chart 6). Chart 5US No Different Than Western Europe On COVID-19 Deaths   Chart 6COVID-19 Least Deadly For Hispanics However, the lockdowns have caused the unemployment rate to soar and exacted a greater toll on the least educated and lowest paid members of society. The election is enflaming the situation. President Trump’s economy has now performed little better for households than President Obama’s economy, assuming they suffer an income and wealth shock at least equal to that of 2008-09 (Chart 7). Chart 7Households Suffer Massive Income Shock Given the collapsing economy, Trump is doubling down on “law and order,” taking an aggressive stance against rioting and looting and thus provoking a backlash. The media is also in a feeding frenzy as the pandemic and economic reopening narratives lose traction and yet Trump perseveres. Polarization is intensifying as a result. Trump’s rhetoric has been egregious as always. His threat to invoke the Insurrection Act of 1807 is not. President George Bush Sr invoked the act to suppress the LA riots in 1992. The act’s provisions, as well as the specific exceptions to the posse comitatus laws and norms, give the president broad discretion in matters precisely like these. The real constraint is not legal but political: any popular backlash from Trump and his advisers in trying to “dominate the battlespace” when it comes to civilians at home. Rioting and looting are also unpopular, so a larger crackdown could easily happen if more unrest takes place. Since the riots are driven by structural factors, they could still escalate, especially if another incident of police brutality occurs. Bottom Line: US unrest is driven by structural and cyclical factors and thus we are in for another “long, hot summer” like 1967. Negative surprises should be expected. The larger risks have to do with the impact on the election and sentiment. Trump’s Polling Was Dropping Even Before The Riots Trump’s approval rating has fallen to the lowest level this year and diverged from the historic average (Chart 8). This increases the risk that the market experiences volatility either in expectation of “regime change” in November or in reaction to Trump’s attempts to regain the initiative. Trump’s deviation from President Obama’s approval at this stage in 2012 is a warning sign (Chart 9). Chart 8Trump’s Polling Drops Below Average Chart 9Trump Falls Off Obama’s Pathway To Reelection Chart 10Trump’s Pandemic Bounce Turns Negative, Unlike Others Trump and the Republican Party received a smaller polling bounce from the pandemic – and year-to-date the bounce is not only gone but has turned negative, comparable only to Vladimir Putin and United Russia (Chart 10). At its peak it was smaller than that of previous US presidents in crisis situations (Table 2, see Appendix). These data come from before the George Floyd incident which will make matters worse for Trump, given that initial polls suggest 35% approve and 52% disapprove of his response to it. The presumptive Democratic nominee Joe Biden is narrowly leading in all major swing states (Chart 11A). Trump has dropped off in critical swing states of Florida, Wisconsin, and Arizona (Chart 11B). Biden is closer to Trump than he should be in states like Ohio and even Texas. Chart 11ATrump Trailing Biden In Swing States Chart 11BTrump Loses Critical Support In FL, WI, AZ Chart 12Biden Polling Better Than Clinton Did Against Trump Biden is tentatively outperforming Hillary Clinton’s showing in 2016 in head-to-head polls against Trump, including in swing states (Chart 12). He has not been on voters’ minds much during the crises. But he has strong support among African American voters, who primarily handed him the party’s nomination, so he may be able to exploit the unrest. Voters indicate they favor him on race relations as well as the coronavirus, though they still favor Trump on the economy. Bottom Line: Trump’s polling was deteriorating before the social unrest. It will suffer more in the near term. But there are still five months until the election. The Market Now Recognizes That Trump Is An Underdog Now, with the country’s biggest cities ablaze, the market is waking up to the fact that Trump and the Republicans have a much greater chance of entirely losing control of the government in just five months. Online gamblers have recently upgraded Biden and the Democrats substantially (Chart 13). Opinion polling has shown weakness but now it is likely to seep into the financial industry’s consciousness that US domestic political risks could still go higher. Policy uncertainty will not fall as sharply as otherwise expected during the economic reopening. Unrest typically reflects negatively on the ruling party, suggesting the status quo is unacceptable and driving voters to vote for change. This is one of the 13 keys to the presidency under the scheme of Professor Allan J. Lichtman, at American University, who has predicted every popular vote outcome since 1984. If one accepts this thesis, then at least five of the keys have now turned against Trump and the GOP. If the economy somehow continues to shrink in the third quarter, or if GDP per capita falls harder than estimated in Chart 7 above, Lichtman’s model will turn against Trump (Table 3, see Appendix). Our own argument has been that a health crisis and surge in unemployment alone are enough to undercut him given his thin margins of victory four years ago and low approval rating. The George Floyd incident reinforces this logic. Not only is voter turnout correlated with the change in unemployment over the president’s term in office, but the correlation holds in swing states and among African Americans. Here is where the devastating impact of COVID-19 among blacks may be relevant (Chart 14). Chart 13Online Bookies Now See Trump Is Underdog Chart 14Hardship For Blacks In Swing States Chart 15Unemployment Pushes Up Voter Turnout (For Blacks And All) If the pandemic and unemployment did not already provide sufficient motivation, then the George Floyd incident might rally this core Democratic Party constituency to turn up at the ballot box (Chart 15). That is a threat to President Trump given that Barack Obama is not on the ballot, so black turnout is unlikely to reach 2008 or 2012 levels. Bottom Line: An increase in African American voter turnout due to unemployment and poor race relations would broaden the electoral pathway to a Democratic victory in November. A Risk To The View: The Silent Majority Could the unrest help Trump? Possibly. Once the peaceful protests turned violent, the possibility emerged that Trump could benefit. The Democrats are not in a strong position whenever they link themselves to economic lockdowns and rioting and looting. It is clear from the police killings and unrest of 2014-15 that more and more people have lost confidence in police treating blacks and whites equally (Chart 16), but they do not make up a majority. Chart 16Over Time, Voters Losing Confidence In Police Fairness Chart 17Majority Sees Racism As Individual, Not Institutional Moreover, two-thirds of citizens, two-thirds of Hispanics, and almost half of blacks believed at that time that racism and discrimination stem from individual actions rather than institutional factors (Chart 17). Confidence and institutional trust will fall during today’s crisis moments but the above polls suggest limits to the protest movement. Generally Americans are satisfied with the work of their local police departments (Chart 18). This includes 72% of blacks. Only about a quarter of Americans report being harassed by the police at any time, according to a Monmouth University poll. Chart 18Silent Majority? Most Americans Satisfied With Local Police Almost 80% of people believe police funds should be increased or kept the same, versus 21% who agree with defunding the police. Only 39% of blacks support such a proposal (Chart 19). If House Democrats pass legislation characterized as taking funds away from police it will hurt them. Chart 19Silent Majority? Americans Don’t Want To Cut Police Funding Finally, regarding the use of the military, 58% of Americans approve of the US military supplementing city police forces, while 30% oppose (Chart 20). George Bush Sr deployed troops in a similar predicament, the LA riots of 1992, albeit with an invitation from the California governor. Chart 20Silent Majority? Americans Mostly Support Military Aid To Police Amid Unrest Legal constraints on Trump’s use of the military are low. Given that the political constraint is also low, a resurgence in violence will likely lead to a crackdown. Trump could benefit if it is managed successfully, but the risk of a bloody mistake that harms or kills civilians would also go up. Bottom Line: Trump could benefit from his pitch as the candidate of law and order if unrest continues, violence worsens, and his actions are deemed to restore order. We will upgrade Trump’s reelection odds if his polling improves and the stock market and economy continue to rebound. Investment Takeaways Historic bouts of unrest show that market volatility occurred in the wake of the 1965-69 disturbances, the 1992 LA riots, the breakdown of order in New Orleans after Hurricane Katrina in 2005, and the protests and riots against police brutality in 2014-15. Unrest did not prevent the market from rallying in all of these cases, but it did in some, and pullbacks also followed unrest periods. In every case presidential approval suffered – and in 1968, 1992, 2006, and 2014 the ruling party suffered losses in the election (Charts 21 A-D). Chart 21AThe ‘Long, Hot Summer’ Saw Inflation, Volatility Chart 21BLA Riots Saw Unemployment, Volatility Chart 21CKatrina Saw Volatility, Presidential Approval Drop Chart 21DFerguson Saw Volatility Amid Falling Unemployment Chart 22Confidence Suffers Amid Social Unrest Furthermore, consumer and business confidence generally suffered in these periods (Chart 22). Trump’s reelection bid could fail to recover, which would make him a lame duck and heighten political risks dramatically. Our longstanding view that the party that wins the White House will also win the senate is reinforced by this year’s polls. The market is reacting to stimulus now but policies look to turn a lot tougher on business. The election puts a self-limiting factor into the equity rally. Either the market sells off in the short run to register the currently likely victory of Joe Biden, who will hike taxes, wages, and regulation, or the market rallies all the way till the election, increasing the chances of President Trump’s reelection, which would revolutionize the global system, especially on trade, and would require a selloff around December. The US dollar faces near-term headwinds as global growth recovers and uncertainty related to COVID-19 abates, but the near term is murky, whereas the major headwinds are over a cyclical time horizon. Our theme of “peak polarization” in the US contrasts starkly with our theme of “European integration” and implies that the euro can continue to advance. However, we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. The risk of a Trump victory is still substantial and we view Europe as a marginal loser in that scenario. We still expect investors to flee to the dollar in the event of any global crisis, even if it originates in the United States.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Table 3Lichtman’s 13 Keys To The Presidency Likely Turning Against Trump … Economy Critical