Latin America

Analysis on Mexico and Central Europe is available on pages 6 and 10, respectively. Highlights Deflationary pressures have been intensifying in Malaysia and the central bank will be forced to cut its policy rate. To play this theme, we recommend receiving 2-year swap rates. In Mexico, pieces are falling into place for stocks to outperform the EM equity benchmark on a sustainable basis. We are also keeping an overweight allocation on Mexican sovereign credit and local currency bonds. In Central Europe (CE), inflation will continue to rise as both labor shortages and ultra-accommodative monetary and fiscal policies promote strong domestic demand. We are downgrading our allocation of CE local currency bonds from overweight to neutral. Malaysia: Besieged By Deflationary Pressures Malaysian interest rates appear elevated given the state of its economy. Deflationary pressures have been intensifying and the central bank will be forced to cut its policy rate. The Malaysian economy continues to face strong deflationary pressures. To play this theme, we recommend receiving 2-year swap rates. We are also upgrading our recommended allocation to Malaysian local currency and U.S. dollar government bonds for dedicated EM fixed-income portfolios from neutral to overweight. The Malaysian economy continues to face strong deflationary pressures, requiring significant rate cuts by the central bank: Chart I-1 shows that the GDP deflator is flirting with deflation, and nominal GDP growth has slowed to the level of commercial banks’ average lending rates. Falling nominal growth amid elevated corporate and household debt levels is an extremely toxic mix (Chart I-2, top panel). Notably, debt-servicing costs for the private sector – both businesses and households – are high at 13.5% of GDP and are also rising (Chart I-2, bottom panel).  Chart I-1The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation The Malaysian Economy Is Flirting With Deflation Chart I-2High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households High Leverage & Debt Servicing Costs Among Businesses & Households Crucially, real borrowing costs are elevated. In real terms, the prime lending rate stands at 5% when deflated by the GDP deflator, and at 3% when deflated by headline CPI. Notably, private credit growth (outstanding business and household loans) has plunged to a 15-year low (Chart I-3), underscoring that real borrowing costs are excessive. Chart I-3Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Malaysia: Credit Growth Is In Freefall Chart I-4Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia's Corporate Sector Is Struggling Malaysia’s corporate sector is struggling. The manufacturing PMI is below the critical 50 threshold and is showing no signs of recovery. Listed companies’ profits are shrinking (Chart I-4, top panel). Poor corporate profitability is prompting cutbacks in capex spending (Chart I-4, middle and bottom panels) and weighing on employment and wages. The household sector has been retrenching; retail sales have been contracting and personal vehicle sales have been shrinking (Chart I-5). The property market – in particular the residential sub-sector – is still in recession. Property sales and starts are falling, and property prices are flirting with deflation (Chart I-6).   Critically, monetary policy easing and exchange rate depreciation are the only levers available to policymakers to reflate the economy. Fiscal policy is constrained as the budget deficit is already large at 3.4% of GDP, and public debt is elevated. Prime Minister Mahathir Mohamad is in fact aiming to reduce the total national debt (including off-balance-sheet debt) back to the government’s ceiling of 54% of GDP (from 80% currently). Chart I-5Malaysian Households Are Retrenching Malaysian Households Are Retrenching Malaysian Households Are Retrenching Chart I-6Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn Malaysia's Property Sector Is In A Downturn   Bottom Line: The Malaysian economy is besieged by deflationary pressures and requires lower borrowing costs. The central bank will deliver rate cuts in the coming months. Investment Recommendations A new trade idea: receive 2-year swap rates as a bet on rate cuts by the central bank. Consistently, for dedicated EM bond portfolios, we are upgrading local currency and U.S. dollar-denominated government bonds from neutral to overweight. Chart I-7Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds Overweight Malaysian Local Currency And U.S. Dollar Government Bonds While we are downbeat on the ringgit versus the U.S. dollar, Malaysian domestic bonds will likely outperform the EM GBI index in common currency terms on a total return basis (Chart I-7, top panel). The same is true for excess returns on the country’s sovereign credit (Chart I-7, bottom panel).     The basis for the ringgit’s more moderate depreciation, especially in comparison with other EM currencies, is as follows: First, foreigners have reduced their holdings of local currency bonds. The share of foreign ownership has declined from 36% in 2015 to 22% now of total outstanding local domestic bonds in the past 4 years (Chart I-8). Hence, currency depreciation will not trigger large foreign capital outflows. Second, the trade balance is in surplus and improving. This will provide a cushion for the ringgit. Finally, the ringgit is cheap in real effective terms which also limits the potential downside (Chart I-9).   Dedicated EM equity portfolios should keep a neutral allocation on Malaysian stocks. We are taking profits on our long Malaysian small-cap stocks relative to the EM small-cap index position. This recommendation has generated a 6.6% gain since its initiation on December 14, 2018. Chart I-8Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Foreigners' Share Of Local Currency Bonds Has Dropped Chart I-9The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Mexico: Raising Our Conviction On Equity Outperformance Mexican local currency bonds, as well as sovereign and corporate credit, have been one of our highest conviction overweights for some time. These positions have played out very well (Chart II-1). Presently, pieces are falling into place for Mexican stocks to outperform the EM equity benchmark on a sustainable basis. First, long-lasting outperformance by Mexican local currency bonds and corporate credit will lead to the stock market’s outperformance relative to the EM benchmark. Chart II-2 shows that when Mexican local currency bond and corporate dollar bond yields fall relative to their EM peers, the Bolsa tends to outperform. In brief, a relative decline in the cost of capital will eventually translate into relative equity outperformance. Chart II-1Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Mexico Vs. EM: Domestic Bonds And Credit Markets Chart II-2Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Mexico: Relative Stock Prices Are Correlated With Relative Cost Of Capital Second – as discussed in detail in our previous Special Report – market worries about Mexico’s fiscal position are overblown, especially relative to other developing nations such as Brazil and South Africa. Orthodox fiscal and monetary policies, as well as low public debt, warrant a lower risk premium in Mexico, both in absolute terms and relative to other EM countries. Moreover, market participants and credit agencies have overstated the precariousness of Pemex’s debt and financing requirements. Pemex U.S. dollar bond yields have been falling steadily compared to EM aggregate corporate bond yields since the announcements of policies aimed at supporting the company’s debt sustainability. We have discussed Pemex’s financial sustainability and its effect on public finances in past reports.1  Third, having cut rates twice since September, the Central Bank of Mexico (Banxico) has embarked on a rate cutting cycle. This is positive for stock prices, as it implies higher equity valuations and will eventually put a floor under the economy.  Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. Banxico members have been vocal about their desire to cut rates further, which is being foreshadowed by the swap market (Chart II-3, top panel). Given that both core and headline inflation have fallen within the target bands, this gives the monetary authorities more room to reduce interest rates. The slowdown in the domestic economy and Andrés Manuel López Obrador’ (AMLO) administration’s tight fiscal policy will enable and encourage Banxico to further ease monetary policy (Chart II-3, bottom panel). Fourth, another positive market catalyst for Mexican equities is the ongoing outperformance of EM consumer staples versus the overall EM index. Consumer staples have a large 35% share of the overall Mexico MSCI stock index, while this sector in the EM MSCI benchmark accounts for only 7%. Therefore, durable outperformance by consumer staples often hints at a relative cyclical outperformance for the Mexican bourse (Chart II-4). Chart II-3Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Mexico: Continue Betting On Lower Rates Chart II-4Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Mexican Equities Are A Play On Consumer Staples Chart II-5Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Mexican Stocks Offer Reasonable Value Finally, Mexican equities are not expensive. Chart II-5 illustrates that according to our cyclically-adjusted P/E ratios, Mexican stocks offer good value in both absolute terms and relative to EM overall. We continue to believe AMLO’s administration is proving to be a pragmatic government with the aim of reducing rent-seeking activities and addressing structural issues such as poverty, corruption and crime. These policies will be positive for the economy over the long run and share prices will move higher in anticipation. Bottom Line: We are reiterating our overweight allocation on Mexican sovereign credit and domestic local currency bonds within their respective EM benchmarks. With further rate cuts on the horizon, yet upside risks to EM local currency bond yields, we continue to recommend a curve steepening trade in Mexico: receiving 2-year and paying 10-year swap rates.  We now have high conviction that Mexican share prices will stage a cyclical outperformance relative to their EM peers. The bottom panel of Chart II-4 on page 8 illustrates that Mexican stocks seem to have formed a major bottom and are about to begin outperforming the EM equity benchmark. Dedicated EM equity managers should have a large overweight allocation to Mexican stocks. Our recommendation of favoring small-caps over large-cap companies in Mexico has been very profitable since we argued for this trade last November. We are taking a 12.9% profit on this position and recommend keeping an overweight allocation to both Mexican large- and small-caps within an EM equity portfolio.   Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Central Europe: An Inflationary Enclave In Deflationary Europe Our macroeconomic theme for Central European (CE) economies – Hungary, Poland and the Czech Republic, elaborated in the linked report, has been as follows: Inflation will continue to rise as both labor shortages and ultra-accommodative monetary as well as fiscal policies in CE promote strong domestic demand. CE economies have stood out as an inflationary enclave in Europe. Notably, CE economies have stood out as an inflationary enclave in Europe. Going forward, inflation will continue to rise across this region, despite the ongoing contraction in European manufacturing. First, Hungary’s and Poland’s central banks are behind the curve – they remain reluctant to hike rates amid rampantly rising inflation within overheating economies (Chart III-1). In turn, real policy rates across CE are becoming more negative and will promote robust money and credit growth (Chart III-2).      Chart III-1CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve CE Central Banks Are Behind The Curve Chart III-2Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Low Real Rates Promote Rampant Credit Growth Policymakers are justifying stimulative policies by stressing ongoing woes in the Europe-wide manufacturing downturn. Yet, they are paying little attention to genuine inflationary pressures in their own economies. Most notably in Hungary, the National Bank of Hungary (NBH) has been aggressively suppressing its policy rate and engaging in a corporate QE program, despite rising inflation and an overheating economy. Similarly, the National Bank of Poland (NBP) seems inclined to cut rates sooner rather than later. On the other end of the spectrum though, the Czech National Bank (CNB) is the only CE central bank to have embarked on a rate hiking cycle over the past 18 months. Going forward, the CNB looks most likely to normalize rates by continuing its hiking cycle. This development will favor rate differentials between it and the rest of CE. As such, we remain long the CZK versus both the HUF and PLN (Chart III-3). Chart III-3Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Favor CZK Versus PLN & HUF Chart III-4Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Germany's Manufacturing Cycles And CE Inflation Second, European manufacturing cycles have historically defined CE inflation trends, with time lags of around 12 to 18 months. However, this time around, the euro area manufacturing recession will not translate into slower CE inflation and growth dynamics (Chart III-4). Above all, booming credit induced by real negative borrowing costs has incentivized robust domestic demand in general and construction activity in particular in CE. In addition, employment growth remains strong and double-digit wage growth has supported strong consumer spending (Chart III-5). As a result, manufacturing production volumes have remained relatively resilient in Hungary and Poland, even as manufacturing output volumes in both Germany and the broader euro area have been contracting (Chart III-6). Chart III-5Strong Domestic Demand In CE… bca.ems_wr_2019_10_31_s3_c5 bca.ems_wr_2019_10_31_s3_c5 Chart III-6...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area ...Entails Divergences In Manufacturing With Euro Area Third, inflationary pressures in CE are both acute and genuine. Wage growth has been rising faster than productivity growth across the region, leading to surging unit labor costs (Chart III-7). Mounting wage pressures reflect widespread labor shortages. Further, output gaps in these economies have turned positive, which has historically been a precursor of inflationary pressures. Finally, fiscal policy in CE will remain very expansionary, supporting strong business and consumer demand. Bottom Line: Super-accommodative monetary and fiscal policies have led to a classic case of overheating within CE, particularly in Hungary and Poland, and less so in the Czech Republic. Chart III-7Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Genuine Inflationary Pressures In Central Europe Chart III-8A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating A Widening Current Account Deficit Is A Symptom Of Overheating Investment Implications Deteriorating current accounts (Chart III-8), rising inflation and behind-the-curve central banks warrant further currency depreciation in both Hungary and Poland. This is why we continue to recommend a short position on both the HUF and PLN versus the CZK. We are closing our Hungarian/euro area relative three-year swap rate trade with a loss of 87 basis points. Our expectation that the market would price in rate hikes in Hungary despite the central bank’s dovishness has not materialized. Investors should remain overweight CE equities within an EM portfolio due to strong domestic demand in these economies and no direct economic exposure to China. As we expect EM equities to underperform DM stocks, we continue to recommend underweighting CE versus the core European markets. We are downgrading our allocation to CE local currency bonds from overweight to neutral within an EM domestic bond portfolio. The primary reason is a risk of a selloff in core European rates.   Anddrija Vesic Research Analyst andrija@bcaresearch.com     Footnotes 1. Please see Emerging Markets Strategy, "Mexico: The Best Value In EM Fixed Income," dated April 23, 2019 and "Mexico: Crying Out For Policy Easing," dated September 5, 2019, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The U.S. and China are moving toward formalizing a trade ceasefire that reduces geopolitical risk in the near term. The risk of a no-deal Brexit is finished – removing a major downside to European assets. Spanish elections reinforce our narrative of general European political stability. Go long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Geopolitical risks will remain elevated in Turkey, rise in Russia, but remain subdued in Brazil. A post-mortem of Canada’s election suggests upside to fiscal spending but further downside to energy sector investment over the short to medium term. Feature After a brief spike in trade war-related geopolitical risk just prior to the resumption of U.S.-China negotiations, President Trump staged a tactical retreat in the trade war. Chart 1Proxy For Trade War Shows Falling Risk Proxy For Trade War Shows Falling Risk Proxy For Trade War Shows Falling Risk Negotiating in Washington, President Trump personally visited the top Chinese negotiator Liu He and the two sides announced an informal “phase one deal” to reverse the summer’s escalation in tensions: China will buy $40-$50 billion in U.S. agricultural goods while the U.S. will delay the October 15 tariff hike. More difficult issues – forced tech transfer, intellectual property theft, industrial subsidies – were punted to later. The RMB is up 0.7% and our own measures of trade war-related risk have dropped off sharply (Chart 1). We think these indicators will be confirmed and Trump’s retreat will continue – as long as he has a chance to save the 2020 economic outlook and his reelection campaign. Odds are low that Trump will be removed from office by a Republican-controlled senate – the looming election provides the republic with an obvious recourse for Trump’s alleged misdeeds. However, Trump’s approval rating is headed south. While it is around the same level as President Obama’s at this point in his first term, Obama’s started a steep and steady rise around now and ended above 50% for the election, a level that is difficult to foresee for Trump (Chart 2). So Trump desperately needs an economic boost and a policy victory to push up his numbers. Short of passing the USMCA, which is in the hands of the House Democrats, a deal with China is the only way to get a major economic and political win at the same time. Hence the odds of Presidents Trump and Xi actually signing some kind of agreement are the highest they have been since April (when we had them pegged at 50/50). Trump will have to delay the December 15 tariff hike and probably roll back some of the tariffs over next year as continuing talks “make progress,” though we doubt he will remove restrictions on tech companies like Huawei. Still, we strongly believe that what is coming is a détente rather than the conclusion of the Sino-American rivalry crowned with a Bilateral Trade Agreement. Strategic tensions are rising on a secular basis between the two countries. These tensions could still nix Trump’s flagrantly short-term deal-making, and they virtually ensure that some form of trade war will resume in 2021 or 2022, if indeed a ceasefire is maintained in 2020. Both sides are willing to reduce immediate economic pain but neither side wants to lose face politically. Trump will not forge a “grand compromise.” Our highest conviction view all along has been – and remains – that Trump will not forge a “grand compromise” ushering in a new period of U.S.-China economic reengagement in the medium or long term. China’s compliance, its implementation of structural changes, will be slow or lacking and difficult to verify at least until the 2020 verdict is in. This means policy uncertainty will linger and business confidence and capex intentions will only improve on the margin, not skyrocket upward (Chart 3). Chart 2Trump Needs A Policy Win And Economic Boost How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Chart 3Sentiment Will Improve ... Somewhat Sentiment Will Improve ... Somewhat Sentiment Will Improve ... Somewhat The problem for bullish investors is that even if global trade uncertainty falls, and the dollar’s strength eases, fear will shift from geopolitics to politics, and from international equities to American equities (Chart 4). Trump, hit by impeachment and an explosive reaction to his Syria policy, is entering into dangerous territory for the 2020 race. Trump’s domestic weakness threatens imminent equity volatility for two reasons. Chart 4American Outperformance Falls With Trade Tensions bca.gps_wr_2019_10_25_c4 bca.gps_wr_2019_10_25_c4 Chart 5Democratic Win In 2020 Is Market-Negative Democratic Win In 2020 Is Market-Negative Democratic Win In 2020 Is Market-Negative First, if Trump’s approval rating falls below today’s 42%, investors will begin pricing a Democratic victory in 2020, i.e. higher domestic policy uncertainty, higher taxes, and the re-regulation of the American economy (Chart 5). This re-rating may be temporarily delayed or mitigated by the fact that former Vice President Joe Biden is still leading the Democratic Party’s primary election race. Biden is a known quantity whose policies would simply restore the Obama-era status quo, which is only marginally market-negative. Contrary to our expectations Biden's polling has not broken down due to accusations of foul play in Ukraine and China. Nevertheless, Senator Elizabeth Warren will gradually suck votes away from fellow progressive Senator Bernie Sanders and in doing so remain neck-and-neck with Biden (Chart 6). When and if she pulls ahead of Biden, markets face a much greater negative catalyst. (Yes, she is also capable of beating Trump, especially if his polling remains as weak as it is.) Chart 6Warren Will Rise To Front-Runner Status With Biden How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Second, if Trump becomes a “lame duck” he will eventually reverse the trade retreat above and turn into a loose cannon in his final months in office. Right now we see a decline in geopolitical risk, but if the economy fails to rebound or the China ceasefire offers little support, then Trump will at some point conclude that his only chance at reelection is to double down on his confrontation with America’s enemies and run as a “war president.” A cold war crisis with China, or a military confrontation with Iran (or North Korea, Venezuela, or some unexpected target) could occur. But since September we have been confirmed in believing that Trump is trying to be the dealmaker one last time before any shift to the war president. Bottom Line: The “phase one” trade deal is really just a short-term ceasefire. Assuming it is signed by Trump and Xi, it suggests no increase in tariffs and some tariff rollback next year. However, as recessionary fears fade, and if Trump’s reelection chances stabilize, U.S.-China tensions on a range of issues will revive – and there is no getting around the longer-term conflict between the two powers. For this and other reasons, we remain strategically short RMB-USD, as the flimsy ceasefire will only briefly see RMB appreciation. BoJo's Brexit Bluff Is Finished Our U.K. indicator captured a sharp decline in political risk in the past two weeks and our continental European indicators mirrored this move (Chart 7). The risk that the U.K. would fall out of the EU without a withdrawal agreement has collapsed even further than in September, when parliament rejected Prime Minister Boris Johnson’s no-deal gambit and we went long GBP-USD. We have since added a long GBP-JPY trade. Chart 7Collapse In No-Deal Risk Will Echo Across Europe Collapse In No-Deal Risk Will Echo Across Europe Collapse In No-Deal Risk Will Echo Across Europe Chart 8Unlikely To See Another Tory/Brexit Rally Like This Unlikely To See Another Tory/Brexit Rally Like This Unlikely To See Another Tory/Brexit Rally Like This The risk of “no deal” is the only reason to care about Brexit from a macro point of view, as the difference between “soft Brexit” and “no Brexit” is not globally relevant. What matters is the threat of a supply-side shock to Europe when it is already on the verge of recession. With this risk removed, sentiment can begin to recover (and Trump’s trade retreat also confirms our base case that he will not impose tariffs on European cars on November 14). Since Brexit was the only major remaining European political risk, European policy uncertainty will continue to fall. The Halloween deadline was averted because the EU, on the brink of recession, offered a surprising concession to Johnson, enabling him to agree to a deal and put it up for a vote in parliament. The deal consists of keeping Northern Ireland in the European Customs Union but not the whole of the U.K., effectively drawing a new soft border at the Irish Sea. The bill passed the second reading but parliament paused before finalizing it, rejecting Johnson’s rapid three-day time table. The takeaway is that even if an impending election returns Johnson to power, he will seek to pass his deal rather than pull the U.K. out without a deal. This further lowers the odds of a no-deal Brexit as it illuminates Johnson's preferences, which are normally hidden from objective analysis. True, there is a chance that the no-deal option will reemerge if Johnson’s deal totally collapses due to parliamentary amendments, or if the U.K. and EU have failed to agree to a future relationship by the end of the transition period on December 31, 2020 (which can be extended until the end of 2022). However, the chance is well below the 30% which we deemed as the peak risk of no-deal back in August. Johnson created the most credible threat of a no-deal exit that we are likely to see in our lifetimes – a government with authority over foreign policy determined to execute the outcome of a popular referendum – and yet parliament stopped it dead in its tracks. Johnson does not want a no-deal recession and his successors will not want one either. After all, the support for Brexit and for the Tories has generally declined since the referendum, and the Tories are making a comeback on the prospect of an orderly Brexit (Chart 8). All eyes will now turn toward the impending election. Opinion polls still show that Johnson is likely to be returned to power (Chart 9). The Tories have a prospect of engrossing the pro-Brexit vote while the anti-Brexit opposition stands divided. No-deal risk only reemerges if the Conservatives are returned to power with another weak coalition that paralyzes parliament. Chart 9Tory Comeback As BoJo Gets A Deal Tory Comeback As BoJo Gets A Deal Tory Comeback As BoJo Gets A Deal Chart 10Brexit Means Greater Fiscal Policy Brexit Means Greater Fiscal Policy Brexit Means Greater Fiscal Policy Whatever the election result, we maintain our long-held position that Brexit portends greater fiscal largesse (Chart 10). The agitated swath of England that drove the referendum result will not be assuaged by leaving the European Union – the rewards of Brexit are not material but philosophical, so material grievances will return. Voter frustration will rotate from the EU to domestic political elites. Voters will demand more government support for social concerns. Johnson’s own government confirms this point through its budget proposals. A Labour-led government would oversee an even more dramatic fiscal shift. Our GeoRisk indicator will fall on Brexit improvements but the question of the election and next government will ensure it does not fall too far. Our long GBP trades are tactical and we expect volatility to remain elevated. But the greatest risk, of no deal, is finished, so it does make sense for investors with a long time horizon to go strategically long the pound. The greatest risk, of a no deal Brexit, is finished. Bottom Line: Brexit posed a risk to the global economy only insofar as it proved disorderly. A withdrawal agreement by definition smooths the process. Continental Europe will not suffer a further shock to net exports. The Brexit contribution to global policy uncertainty will abate. The pound will rise against the euro and yen and even against the dollar as long as Trump’s trade retreat continues. Spain: Further Evidence Of European Stability We have long argued that the majority of Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 11). This month’s protests in Barcelona following the Catalan independence leaders’ sentencing are at the lower historical range in terms of size – protest participation peaked in 2015 along with support for independence (Table 1). Table 1October Catalan Protests Unimpressive How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Our Spanish risk indicator is showing a decline in political risk (Chart 12). However, we believe that this fall is slightly overstated. While the Catalan independence movement is losing its momentum, the ongoing protests are having an impact on seat projections for the upcoming election.  Chart 11Catalonians Not Demanding Independence Catalonians Not Demanding Independence Catalonians Not Demanding Independence Chart 12Right-Wing Win Could Surprise Market, But No Worries Right-Wing Win Could Surprise Market, But No Worries Right-Wing Win Could Surprise Market, But No Worries Since the April election, the right-wing bloc of the People’s Party, Ciudadanos, and Vox has been gaining in the seat projections at the expense of the Socialist Party and Podemos. Over the course of the protests, the left-wing parties’ lead over the right-wing parties has narrowed from seven seats to one (Chart 13). If this momentum continues, a change of government from left-wing to right-wing becomes likely. However, a right-wing government is not a market-negative outcome, and any increase in risk on this sort of election surprise would be short-lived. The People’s Party has moderated its message and focused on the economy. Besides pledging to limit the personal tax rate to 40% and corporate tax rate to 20%, the People’s Party platform supports innovation, R&D spending, and startups. The party is promising tax breaks and easier immigration rules to firms and employees pursuing these objectives. Chart 13Spanish Right-Wing Parties Narrow Gap With Left How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Another outcome of the election would be a governing deal between PSOE and Podemos, along with case-by-case support from Ciudadanos. After a shift to the right lost Ciudadanos 5% in support since the April election, leader Albert Rivera announced in early October that he would be lifting the “veto” on working with the Socialist Party. If the right-wing parties fall short of a majority, then Rivera would be open to talks with Socialist leader Pedro Sanchez. A governing deal between PSOE, Podemos, and Ciudadanos would have 175 seats, as of the latest projections, which is just one seat short of a majority. As we go to press, this is the only outcome that would end Spain’s current political gridlock, and would therefore be the most market-positive outcome. Bottom Line: Despite having a fourth election in as many years, Spanish political risk is contained. This is reinforced by a relatively politically stable backdrop in continental Europe, and marginally positive developments in the U.K. and on the trade front. We remain long European versus U.S. technology, and long EU versus Chinese equities. We will also be looking to go long EUR/USD when and if the global hard data turn. Following our European Investment Strategy, we recommend going long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Turkey, Brazil, And Russia Chart 14Turkish Risk Will Rise Despite 'Ceasefire' Turkish Risk Will Rise Despite 'Ceasefire' Turkish Risk Will Rise Despite 'Ceasefire' Turkey’s political risk skyrocketed upward after we issued our warning in September (Chart 14). We maintain that the Trump-Erdogan personal relationship is not a basis for optimism regarding Turkey’s evading U.S. sanctions. Both chambers of the U.S. Congress are preparing a more stringent set of sanctions, focusing on the Turkish military, in the wake of Trump’s decision to withdraw U.S. forces from northeast Syria. At a time when Trump needs allies in the senate to defend him against eventual impeachment articles, he is not likely to veto and risk an override. Moreover, Turkey’s military incursion into Syria, which may wax and wane, stems from economic and political weakness at home and will eventually exacerbate that weakness by fueling the growing opposition to Erdogan’s administration and requiring more unorthodox monetary and fiscal accommodation. It reinforces our bearish outlook on Turkish lira and assets. Chart 15Brazilian Risk Will Not Re-Test 2018 Highs Brazilian Risk Will Not Re-Test 2018 Highs Brazilian Risk Will Not Re-Test 2018 Highs Brazil’s political risk has rebounded (Chart 15). The Senate has virtually passed the pension reform bill, as expected, which raises the official retirement age for men and women to 65 and 63 respectively. This will generate upwards of 800 billion Brazilian real in savings to improve the public debt profile. Of course, the country will still run primary deficits and thus the public debt-to-GDP ratio will still rise. Now the question shifts to President Jair Bolsonaro and his governing coalition. Bolsonaro’s approval rating has ticked up as we expected (Chart 16). If this continues then it is bullish for Brazil because it suggests that he will be able to keep his coalition together. But investors should not get ahead of themselves. Bolsonaro is not an inherently pro-market leader, there is no guarantee that he will remain disciplined in pursuing pro-productivity reforms, and there is a substantial risk that his coalition will fray without pension reform as a shared goal (at least until markets riot and push the coalition back together). Therefore we expect political risk to abate only temporarily, if at all, before new trouble emerges. Furthermore, if reform momentum wanes next year, then Brazil’s reform story as a whole will falter, since electoral considerations emerge in 2021-22. Hence it will be important to verify that policymakers make progress on reforms to tax and trade policy early next year. Our Russian geopolitical risk indicator is also lifting off of its bottom (see Appendix). This makes sense given Russia’s expanding strategic role (particularly in the Middle East), its domestic political troubles, and the risks of the U.S. election. The latter is especially significant given the risk (not our base case, however) that a Democratic administration could take a significantly more aggressive posture toward Russia. Political risk in Turkey and Russia will continue to rise. Bottom Line: Political risk in Turkey and Russia will continue to rise. Russia is a candidate for a “black swan” event, given the eerie quiet that has prevailed as Putin devotes his fourth term to reducing domestic political instability. Brazil, on the other hand, has a 12-month window in which reform momentum can be reinforced, reducing whatever spike in risk occurs in the aftermath of the ruling coalition’s completion of pension reform. Canada: Election Post-Mortem Prime Minister Justin Trudeau returned to power at the head of a minority government in Canada’s federal election (Chart 17). The New Democratic Party (NDP) lost 15 seats from the last election, but will have a greater role in parliament as the Liberals will need its support to pass key agenda items (and a formal governing coalition is possible). The NDP’s result would have been even worse if not for its last-minute surge in the polls after the election debates and Trudeau’s “blackface” scandal. Chart 17Liberals Need The New Democrats Now How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 The Conservative Party won the popular vote but only 121 seats in parliament, leaving the western provinces of Alberta and Saskatchewan aggrieved. The Bloc Québécois, the Quebec nationalist party, gained 22 seats to become the third-largest party in the House. Energy investment faces headwinds in the near-term. The Liberal Party will face resistance from the Left over the Trans Mountain pipeline. Trudeau will not necessarily have to sacrifice the pipeline to appease the NDP. He may be able to work with Conservatives to advance the pipeline while working with the NDP on the rest of his agenda. But on the whole the election result is the worst-case scenario for the oil sector and political questions will have to be resolved before Canada can take advantage of its position as a heavy crude producer near the U.S. Gulf refineries in an era in which Venezuela is collapsing and Saudi Arabia is exposed to geopolitical risk and attacks. More broadly, the Liberals will continue to endorse a more expansive fiscal policy than expected, given Canada’s low budget deficits and the need to prevent minor parties from eating away at the Liberal Party’s seat count in future. Bottom Line: The Liberal Party failed to maintain its single-party majority. Trudeau’s reliance on left-wing parties in parliament may prove market-negative for the Canadian energy sector, though that is not a forgone conclusion. Over the longer term the sector has a brighter future.   Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Appendix GeoRisk Indicator TRADE WAR GEOPOLITICAL RISK INDICATOR TRADE WAR GEOPOLITICAL RISK INDICATOR U.K.: GeoRisk Indicator U.K.: GEOPOLITICAL RISK INDICATOR U.K.: GEOPOLITICAL RISK INDICATOR France: GeoRisk Indicator FRANCE: GEOPOLITICAL RISK INDICATOR FRANCE: GEOPOLITICAL RISK INDICATOR Germany: GeoRisk Indicator GERMANY: GEOPOLITICAL RISK INDICATOR GERMANY: GEOPOLITICAL RISK INDICATOR Spain: GeoRisk Indicator SPAIN: GEOPOLITICAL RISK INDICATOR SPAIN: GEOPOLITICAL RISK INDICATOR Italy: GeoRisk Indicator ITALY: GEOPOLITICAL RISK INDICATOR ITALY: GEOPOLITICAL RISK INDICATOR Canada: GeoRisk Indicator CANADA: GEOPOLITICAL RISK INDICATOR CANADA: GEOPOLITICAL RISK INDICATOR Russia: GeoRisk Indicator RUSSIA: GEOPOLITICAL RISK INDICATOR RUSSIA: GEOPOLITICAL RISK INDICATOR Turkey: GeoRisk Indicator TURKEY: GEOPOLITICAL RISK INDICATOR TURKEY: GEOPOLITICAL RISK INDICATOR Brazil: GeoRisk Indicator BRAZIL: GEOPOLITICAL RISK INDICATOR BRAZIL: GEOPOLITICAL RISK INDICATOR Taiwan: GeoRisk Indicator TAIWAN: GEOPOLITICAL RISK INDICATOR TAIWAN: GEOPOLITICAL RISK INDICATOR Korea: GeoRisk Indicator KOREA: GEOPOLITICAL RISK INDICATOR KOREA: GEOPOLITICAL RISK INDICATOR What's On The Geopolitical Radar? How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Section III: Geopolitical Calendar

Highlights Analysis on Chile is available below. EM local bond yields have decoupled from their traditional macro drivers. This could be a sign that EM domestic bonds are entering a New Normal. We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as their currencies depreciate. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to investor complacency or represents a sustainable paradigm shift. We are instituting a buy stop on the MSCI EM equity index at 1075. If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Feature EM local currency bond yields have fallen below their 2013 lows (Chart I-1) – levels not reached since before the Federal Reserve-induced “Taper Tantrum” in the spring of 2013, when EM domestic bond yields spiked and currencies plunged. Crucially, in a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies (Chart I-1), commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle (Chart I-2). Chart I-1EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies Chart I-2EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers   Will this decoupling persist, or will the past relationship be re-established? In other words, have EM local currency bonds entered a New Normal – a paradigm where their yields behave like DM yields – falling during deflationary periods and rising during business cycle recoveries? What We Got Right And Wrong We had not been anticipating such a large drop in EM domestic bond yields this year. Our analysis has been based on the following pillars: That the global trade and manufacturing recession would persist until late 2019, and that such an outcome would herald lower commodities prices and weaker EM currencies. Falling resource prices and EM currency deprecation, consistent with the history shown in Chart I-1 and I-2, would lead to a foreign investor exodus from EM local bonds, reinforcing currency depreciation and somewhat higher yields.   Our theme that the global trade and manufacturing recession has been driven by weak domestic demand in China and the rest of the EM has played out quite well; commodities prices have been weak and EM currencies have depreciated. In addition, the broad trade-weighted dollar has been strong and DM bond yields have plunged in the past 12 months, in line with our theme of a global growth slump. In a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle. Nevertheless, our view of a selloff in EM domestic bonds has not panned out. In other words, our spot-on macro analysis has not translated into a successful investment call on the direction of EM local yields. The reason has been a change in the relationship between EM bond yields and their typical global macro drivers, specifically EM currencies. A potential counter-argument could be that falling DM bond yields have pushed EM local yields lower. However, contrary to the widespread consensus view, both EM local bond yields and currencies have illustrated a relatively weak correlation with U.S. bond yields (Chart I-3). All in all, even though our macro view has been on the ball, we have been flat-footed by the shifting relationship between EM domestic bond yields and their traditional macro drivers as illustrated in Chart I-1 and I-2.  Finally, even though EM bond yields have plunged, their total returns in U.S. dollar terms have not been spectacular (Chart I-4, top panel). Crucially, the EM GBI total return index in dollar terms has not outperformed that of duration-matched U.S. Treasurys (Chart I-4, bottom panel). Chart I-3No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields Chart I-4EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys   Our macro views and themes have been positive for DM bonds. Fixed-income investors who favored U.S. Treasurys over EM local bonds have not underperformed by much in the past 12 months and have actually dramatically outperformed in 2018. Complacency Or A New Normal? There are two possible scenarios for EM domestic bonds going forward: Bullish Scenario: EM Local Bonds Have Entered A New Normal We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. This implies the past relationships between EM domestic yields on the one hand, and EM currencies and global macro variables on the other hand have permanently reversed. If EM domestic bonds have entered a New Normal, central banks in high-yielding EMs should cut interest rates during global growth slowdowns even if their exchange rate depreciates. Besides, their local bond yields should move lower despite currency weakness. If these two conditions are satisfied, one can argue that a major regime shift in EM interest rates has taken place. Ongoing rate cuts by a few of EM central banks - despite lingering weakness in their currencies - could be an indication that we are entering such a regime shift (Chart I-5). We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. We are open to accept this idea of a New Normal. Central banks in any economy where growth is slowing and inflation is low or falling should reduce interest rates even if their exchange rate depreciates. This will be a positive development for these countries, as it will make their monetary policy counter-cyclical - as it should be. One pre-condition for EM domestic bonds entering a New Normal is for the share of foreign investors holding of local currency bonds to decline. It is occurring at the margin in some countries. In Turkey, South Africa, Malaysia and Poland, the share of foreign investors in domestic bonds has fallen (Chart I-6). Yet, this phenomenon is not occurring in Indonesia, Russia, Colombia and Mexico. Chart I-5Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Chart I-6Falling Share Of Foreign Investors Falling Share Of Foreign Investors Falling Share Of Foreign Investors   Negative Scenario: Investor Complacency Ends Chart I-7EM Currencies Correlate With Global Business Cycle And Commodities Prices bca.ems_wr_2019_10_24_s1_c7 bca.ems_wr_2019_10_24_s1_c7 Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. Conditional on our view that EM currencies remain at risk of further depreciation panning out, EM local bonds are unlikely to avoid foreign outflows and higher yields under this scenario. This is especially true for the EM countries with high foreign ownership of local bonds. In theory, various macro forces such as expectations of domestic monetary policy, fiscal policy, inflation prospects, domestic business cycles, individual countries’ exchange rates as well as global interest rates should influence EM local bond yields. In reality, however, EM local yields have historically risen during periods of global business cycle downturns and falling commodities prices. The channel was via EM currencies, which depreciated during these periods (Chart I-7). Thereby, the primary driver for local bond yields has historically been swings in domestic exchange rates. In turn, the basis for this high sensitivity of EM domestic bond yields to their exchange rates has been due to the large share of foreign ownership. Table I-1 illustrates that the share of local currency government bonds held by foreign investors is high in the majority of EM countries. The exceptions are China, India, Korea, the Philippines and Chile. The data for Brazil are suspect. It is difficult to believe that foreigners own a mere 12% and declining share of Brazilian local currency bonds. Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. What is critical, is that international investors care about the returns on their investments in U.S. dollars, euros or Japanese yen. Hence, they are very sensitive to exchange rates. Historically, foreign investors flee EM local bond markets when EM currencies depreciate, and vice versa. Chart I-8 illustrates the wide gap between total returns on EM domestic bonds in local currency and U.S. dollar terms. Table I-1Share Of Domestic Bonds Held By Foreign Investors EM Local Bonds: A New Normal? EM Local Bonds: A New Normal? Chart I-8EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility   In short, most investment return volatility in EM local bonds can be attributed to exchange rates – i.e., investments in EM local bonds have in practical terms constituted a bet on their exchange rates. If EM currencies experience another downleg, foreign investors’ patience might run out, causing a spike in EM local yields. Bottom Line: It is still early to conclude if a New Normal in EM domestic bonds has already taken hold. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to an unrelenting search for yield or represents a paradigm shift. Reasons Why Local EM Yields Could Rise There are two macro risks to EM local bonds: 1.  A deepening/persisting growth slump in China Deteriorating Chinese domestic growth or a weaker RMB remain the key risks to the rest of the world. In brief, odds are high that China will continue exporting deflation to the rest of the world. Shrinking Chinese imports imply that the rest of the world’s export revenues emanating from their shipments to China are contracting (Chart I-9). A negative growth shock in EM economies that are exposed to China heralds both weaker currencies and lower interest rates. Given that high-yielding EM local bonds yields have risen historically during negative growth shocks, we are reluctant to chase these EM yields lower. This has been, and remains, our main thesis for high-yielding EM bond markets. 2.  Rising inflation in the U.S. Despite commentators’ preoccupation with global deflation and recession, U.S. core inflation is moving up. The equal-weighted average of various core measures presently stands at 2.2% and is drifting higher (Chart I-10). Chart I-9Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chart I-10U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising   Besides, BCA Research’s U.S. wage tracker and unit labor costs have been accelerating (Chart I-11). The tight labor market in the U.S. suggest that risks to wages and unit labor costs and, ultimately, inflation are skewed to the upside. Chart I-11U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating Unless U.S. growth slows much further, America’s fixed-income markets will at some point wake up to the reality of rising inflation. This will produce a shift up in the entire yield curve. Such a spike in U.S. Treasury yields will lead to a period of dollar strength and a selloff in overbought EM local bonds. Bottom Line: EM local bonds are discounting a goldilocks scenario. The two most likely risks that investors should monitor are a deepening growth slump in China and upside surprises in U.S. consumer price inflation.  Investment Strategy: Instituting A Buy Stop on EM Equities Given our negative stance on EM exchange rates, we have been receiving rates in EM countries where interest rates historically dropped amid currency deprecation. These include Korea, Chile and Mexico (the latter due to the value in local rates). For a dedicated EM local bond portfolio, our recommended overweights have been: Mexico, Russia, Central Europe, Chile, Korea and Thailand. Our underweights have been South Africa, Turkey, Indonesia, the Philippines and Argentina. Clients can always find our country allocation and trades for the EM local bond universe at the end of our weekly reports - please refer to page 14 - or on our website.  Also, gauging the direction of EM local bond yields is critical not only to fixed-income portfolio managers but to equity managers as well. Chart I-12 illustrates that EM equities rally when their domestic bond yields are falling. The failure of EM share prices to rally in recent months amid plunging EM local bond yields has been due to shrinking corporate profits. We are instituting a buy stop on the MSCI EM equity index at 1075. Any pick-up in EM domestic bond yields without recovery in EM corporate earnings will cause a major drop in EM equities. As to our EM equity strategy, our negative view is currently being challenged by the reaction of global share prices to negative profits and growth data releases. Despite very weak global trade and manufacturing data as well as downbeat profits from cyclical sectors, U.S. high-beta stocks and global cyclicals – an equal-weighted average of global industrials, materials and semiconductor stocks - have held up well (Chart I-13). Chart I-12EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields Chart I-13Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up   This could reflect investor complacency or it could be that the equity market is sensing an imminent recovery in global growth that we do not see in data. In particular, DM equities are at a critical juncture – not only the S&P 500 but also euro area stock prices are flirting with their previous highs (Chart I-14). Chart I-14Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance If they relapse from here, it will signify a bear market. On the other hand, if these equity markets break out, it would suggest that a major upleg is in the making. Even though EM share prices are well below their previous highs, they are also at a make or break juncture. Therefore, we are instituting a buy stop on the MSCI EM equity index at 1075 (Chart I-15). If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Chart I-15We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chile: Structural Equity De-Rating The latest violent protests in Chile have raised doubts about its socio-political and economic stability. As a result, Chilean share prices could be facing both absolute and relative (versus other EM bourses) de-ratings. We are downgrading this bourse from overweight to neutral within an EM equity portfolio, reiterating our short position in the peso versus the dollar, and continue to bet on lower rates and falling inflation cyclically, as discussed in great length in our recent report. Chilean stocks have always been among the most expensive within the EM universe due to the nation’s economic and socio-political stability. The violent protests now warrant a structural de-rating of equity valuations (Chart II-1). Chart II-1Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective First, the government will be forced to adopt much more populist policies, such as the recently announced raise in minimum wages, pension payments and healthcare benefits. Unit labor costs for businesses are set to rise substantially, eating into corporate profit margins. Second, in line with more populist policies, larger budget deficits and structurally higher inflation will cause the long-end of the yield curve to rise. Higher interest rates will put downward pressure on equity multiples. Finally, equity investors will require a higher risk premium to invest in this bourse. Chile’s equity valuation premium versus EM overall will shrink. Bottom Line: The central bank will have to cut rates by a larger margin: continue receiving 3-year swap rates. A recession is unavoidable as business confidence will plunge and derail hiring and investments. Inflation will fall much further cyclically: bet on lower inflation by going long 3-year local currency bonds and shorting their inflation-linked counterparts. Continue shorting the peso versus the U.S. dollar. Downgrade the allocation to Chilean stocks from overweight to neutral within an EM equity portfolio. Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Analysis on Chile is available below. Highlights Major equity leadership rotations normally occur around bear markets or corrections. Hence, a major broad selloff will likely be a precondition for EM, commodities, global cyclicals and value stocks to commence outperforming. The odds that EM equities will underperform the S&P 500 or DM share prices in an equity drawdown are 65-70%. A weaker dollar is essential to EM outperformance. We remain bullish on the dollar and are underweight/short EM. Feature The current decade has been characterized by the substantial outperformance of growth versus value stocks, the S&P 500 versus emerging and other international markets. BCA held its annual conference in New York last week. One of the key topics that investors wanted to get a handle on was the potential for a leadership rotation in global equity markets. The current decade has been characterized by the substantial outperformance of growth versus value stocks, the S&P 500 versus emerging and other international markets, FAANG share prices versus commodities and “old economy” stocks. Is this trend about to reverse? Opinions among our conference speakers certainly differed. Some still showed a penchant for growth stocks and U.S. equities, while others recommended global value and EM stocks. Our Themes For The Decade Our key long-term themes – laid out in our June 8, 2010 Special Report titled How To Play Emerging Market Growth In The Coming Decade1 – have shaped our investment strategy over the past decade have been: Commodities and materials and energy equity sectors as well as machinery stocks will be in a bear market because Chinese capital spending has peaked. Hence, investors should avoid EMs that are very sensitive to resource prices. Favoring EM/Chinese consumer plays, namely technology as well as healthcare stocks in general and healthcare equipment stocks in particular, is the way to play China/EM growth this decade. Given tech and healthcare account for a smaller weighting in EM stock indexes than in DM ones, we have been recommending that investors underweight EM against DM stocks. Needless to say, these themes have panned out extremely well, with EM, resources, commodities-related and machinery equity sectors underperforming massively (Chart I-1), and tech, consumer and healthcare stocks outperforming (Chart I-2). These themes have guided our strategy over the past nine years, leading us to be underweight EM equities in favor of the S&P 500, which is heavily dominated by tech, consumer and healthcare companies. Chart I-1China Capex Plays Have Underperformed This Decade China Capex Plays Have Underperformed This Decade China Capex Plays Have Underperformed This Decade Chart I-2Our Favorites For This Decade Have Outperformed Our Favorites For This Decade Have Outperformed Our Favorites For This Decade Have Outperformed Any investment trend has a beginning and an end. It is essential not to overstay in winning strategies. Critically, Chart I-3 shows that the magnitude of the rise in FAANG stocks over the past 10 years is comparable to bubbles of previous decades. This chart compares asset prices in real (inflation-adjusted) U.S. dollar terms. Chart I-3FAANG And Previous Bubbles In Perspective FAANG And Previous Bubbles In Perspective FAANG And Previous Bubbles In Perspective Only history will tell whether FAANGs are currently in a bubble or not. Presently, we do not have a high conviction view on this matter. However, even if they are not in a bubble, they are extremely overbought and expensive. Their failure to break above their 2018 highs is a negative technical signal. Altogether, this warrants a cautious stance on the absolute performance of FAANGs. Bottom Line: Regardless of the direction of FAANG stocks, odds are that EM share prices will relapse in absolute terms before a sustainable bottom emerges. For a detailed discussion on this, please refer to pages 6-9. In such a scenario, it is hard to envision FAANG stocks rallying. They may continue outperforming on a relative basis, but they will still deflate in absolute terms. Equity Rotations Occur Around Bear Markets The relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs. With respect to equity leadership rotation, it is crucial to note that equity leadership rotations typically occur during or after bear markets and/or corrections in global share prices. Chart I-4 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM – and all of them coincided with, or were preceded by, either a bear market or a correction in global share prices. Similarly, the relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs (Chart I-5). Chart I-4EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations EM Versus DM: Equity Rotations Chart I-5Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Global Growth Versus Value: Leadership Rotations Finally, structural trend changes in the relative performance of the global tech sector, energy stocks and materials have also occurred during or after drawdowns in global share prices (Chart I-6). Chart I-6Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Global Technology, Energy And Materials: Leadership Rotations Bottom Line: Major equity leadership rotations normally occur around bear markets or corrections. Hence, a major selloff is likely before EM, commodities, global cyclicals and value stocks begin to outperform. We will contemplate changing our relative equity strategy if a major broad selloff transpires. In such an equity drawdown, there is a 30-35% chance that EM may outperform the S&P 500, as it did during the carnage in global stocks in the fourth quarter of last year. In short, the probability that EM share prices underperform the S&P 500 and DM is 65-70%. A weaker dollar is essential for EM outperformance. BCA’s Emerging Markets Strategy service remains bullish on the dollar and is underweight/short EM. A Breakdown In EM And Global Cyclicals? With China’s manufacturing PMI once again on the rise, it is critical to challenge our view on the Chinese business cycle as well as global manufacturing and trade. In our opinion, the latest rise in the mainland manufacturing PMI is an aberration rather than a new trend: Chinese share prices over the years have been coincident with or leading mainland manufacturing PMI. Stocks are currently pointing to a relapse in the latter (Chart I-7). The message from Chinese share prices is that the latest improvement in the nation’s manufacturing PMI should be faded. Chart I-7Chinese Share Prices And Manufacturing PMI Chinese Share Prices And Manufacturing PMI Chinese Share Prices And Manufacturing PMI The global manufacturing recession is still spreading. The global manufacturing recession is still spreading. This has yet to be discounted in global cyclical equity sectors. The latter have been moving sideways over the past year and a half, despite the contraction in global manufacturing activity (Chart I-8). Equity investors’ patience may be wearing thin as the expected global manufacturing recovery has so far failed to materialize. Chart I-8Global Cyclical Stocks And Manufacturing PMI bca.ems_wr_2019_10_03_s1_c8 bca.ems_wr_2019_10_03_s1_c8 Chart I-9EM EPS And Korean Exports: Moving In Tandem EM EPS And Korean Exports: Moving In Tandem EM EPS And Korean Exports: Moving In Tandem Korean exports in September contracted at a rate close to 10% year-on-year (Chart I-9, top panel). Interestingly, the level of EM corporate earnings per share (EPS) in U.S. dollar terms exhibits a similar pattern with Korean exports (Chart I-9, bottom panel). Both are at the same level they were in 2010. Hence, over this decade EM EPS and Korean exports in U.S. dollar terms have not expanded at all. U.S. high-beta stocks in aggregate as well as share prices of high-beta industrials and technology stocks are close to breaking below their technical support lines (Chart I-10). They could be canaries in a coal mine for the S&P 500. Chart I-10U.S. High-Beta Stocks Are Breaking Down U.S. High-Beta Stocks Are Breaking Down U.S. High-Beta Stocks Are Breaking Down Chart I-11A Bearish Signal For EM And Commodities bca.ems_wr_2019_10_03_s1_c11 bca.ems_wr_2019_10_03_s1_c11 Despite a very weak U.S. manufacturing PMI, the dollar remains well bid. This signifies that the global manufacturing recession emanates from the rest of the world – not the U.S. In fact, the U.S. manufacturing sector has been the last domino to fall. Persistent strength in the greenback is a symptom of weakening global growth. Our Risk-On / Safe-Haven Currency ratio2 – which is agnostic to dollar trends – is plunging, corroborating the downbeat outlook for global growth in general and commodities prices in particular (Chart I-11). Finally, overall EM and Asian high-yield corporate credit spreads are widening versus investment grade ones. This is a sign of rising risk aversion.  EM credit markets and local currency bonds have so far been reasonably resilient, despite the selloff in EM share prices and currencies (Chart I-12). The basis for such decoupling has been the indiscriminate search for yield rather than improving EM growth dynamics. Chart I-12EM Credit Markets Will Recouple To Downside With Stocks And Currencies EM Credit Markets Will Recouple To Downside With Stocks And Currencies EM Credit Markets Will Recouple To Downside With Stocks And Currencies Deteriorating growth will eventually cause a widening of EM credit spreads. Besides, persistent EM currency depreciation will likely lead to outflows from EM high-yield local bond markets. Bottom Line: EM equities, credit markets and high-yielding local currency bonds are at risk of a major selloff. Our list of country allocations across various EM asset classes as well as our trades can always be found at the end of our reports, please refer to pages 14-15. We continue to recommend shorting the following basket of EM currencies versus the dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Chile: Still Favor Bonds Over Stocks; Bet On Lower Inflation We have been betting on sluggish growth, lower interest rates and a weakening currency in Chile. These positions have panned out well as the economy has slowed considerably, local bond yields have plunged and the currency depreciated significantly (Chart II-1, top and middle panels). However, our overweight position in Chilean equities within a dedicated EM stock portfolio has performed poorly (Chart II-1, bottom panel). Is it time to reconsider our position? Chart II-1Our Strategy For Chile Our Strategy For Chile Our Strategy For Chile Having re-examined the cyclical dynamics of this economy and putting it in the context of the global backdrop, we reiterate our investment recommendations. We also see a new investment opportunity within the Chilean fixed-income markets – investors should consider betting on lower inflation expectations, i.e., going long domestic bonds and shorting inflation-linked bonds. We believe the bond market’s medium-to long-term inflation expectations are overstated and will drop in the coming months. The Chilean economy will likely weaken further and inflation is set to drop considerably beyond the near term. Even though the central bank has already cut rates by 100 basis points, it will take both more easing and time before the credit impulse turns positive and lifts domestic demand. The credit impulse for businesses points to a relapse in capital spending (Chart II-2). The adopted fiscal stimulus has been negligible at 0.21% of GDP for 2019 and 2020. While government spending growth is bottoming, overall fiscal expenditures account for 20% of GDP. In brief, they are too small to make a major difference for the economy. Chart II-2Chile: Falling Credit Impulse = Weak Capex Chile: Falling Credit Impulse = Weak Capex Chile: Falling Credit Impulse = Weak Capex With non-mining exports contracting and commodities prices plunging, the export sectors will continue to depress growth. Corporate profits are shrinking and this will dent capital spending and hiring. Critically, rising unit labor costs are depressing corporate profit margins (Chart II-3). The latter have spiked because the output slowdown has not yet been matched by layoffs or lower wage growth. In turn, forthcoming layoffs amid the already rising unemployment rate will certainly lead to considerable wage disinflation (Chart II-4). Chile has seen massive inflows of immigrants from Venezuela in recent years, which will prove to be a major disinflationary force for this economy in the medium-term. Finally, goods price inflation – which has stemmed from currency depreciation – could prevent consumer inflation from falling in the near term. Yet, this phenomena will not be sustainable beyond the near term. Chart II-3Shrinking Profits Will Lead Businesses To Reduce Unit Labor Costs Shrinking Profits Will Lead Businesses To Reduce Unit Labor Costs Shrinking Profits Will Lead Businesses To Reduce Unit Labor Costs Chart II-4Wage Growth Is Unsustainably High Wage Growth Is Unsustainably High Wage Growth Is Unsustainably High On the whole, the fixed-income market will look through currency depreciation-induced goods inflation and begin pricing in much lower inflation expectations. We recommend betting that 3-year inflation expectations will decline from 2.5% to 1.5% in the next 12 months (Chart II-5). We have been receiving 3-year swap rates since May 31st, 2018 and this position remains intact. The peso will continue to depreciate as copper prices fall further. Notably, the real effective exchange rate based on unit labor costs – computed by the OECD – suggests that the peso is still expensive (Chart II-6). The last datapoint is as of September 2019. This is probably due to depreciation in other Latin American currencies. Chart II-5Chile: Inflation Expectations To Plunge Chile: Inflation Expectations To Plunge Chile: Inflation Expectations To Plunge Chart II-6The CLP Is Not Cheap The CLP Is Not Cheap The CLP Is Not Cheap Finally, we are reluctant to downgrade the Chilean bourse within an EM equity portfolio. Policy easing and large underperformance as well as the positive structural outlook should produce a period of outperformance by this stock market amid the selloff in the overall EM equity universe. Local asset allocators should continue favoring bonds versus stocks. Bottom Line: As a new trade for fixed-income investors: We recommend going long 3-year domestic bonds and shorting 3-year inflation-linked bonds.   Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at ems.bcaresearch.com 2      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Pension reform in Brazil is pushing through. The upcoming 12-18 months offer a window of opportunity, most notably on the privatization and tax reform front. Ongoing efforts should sustain an improvement in “animal spirits” in the short term and create some potential for structural improvements over the long term. Nevertheless, Brazil’s slow grinding economic recovery remains vulnerable to a negative external or domestic shock that could cause it to “stall speed”. If structural reforms or the business cycle hit stall speed, financial markets will sell off. Weighing the pros and cons, we are upgrading Brazil from underweight to neutral. Feature Pension Reform Will (Eventually) Pass, But What Next? Recent progress on Brazil’s economic reform agenda is market-positive but is clearly at risk of “stall speed”1 if reform momentum is not sustained after the likely passage of social security cuts. Having cleared the Chamber of Deputies, the pension reform bill is now likely to pass the senate. The first round of voting is expected any day now and the government’s senate leader, Fernando Bezerra, expects the bill to pass the second round by mid-October (Diagram I-1). Diagram I-1Brazil: Pension Reform Timeline Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Chart I-1Pension Bill Will See The Light Of Day Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" The reform is all but certain to be approved by congress, granting the Bolsonaro administration its first major legislative victory. Lower house deputies voted largely in line with party alliances – if this continues in the senate, the bill should rack up the support of at least 56 of the 81 senators – surpassing the 49 votes needed for passage (Chart I-1). We would not be surprised if the bill faced sudden hang-ups in the senate, such as delays or dilutions. The House bill was introduced in February and after some delay passed in August. Rodrigo Maia, President of the Chamber of Deputies, was instrumental in ensuring the bill’s smooth passage. While Senate President Davi Alcolumbre has a similar interest in ensuring its passage, there is no guarantee that it will be smooth. Fragmentation in the senate, for example, is at the highest level ever, unlike the lower house. The bill requires two rounds of voting. Bezerra’s expectation of voting on September 24 and October 15 is already a delay from the initial projection of September 18 and October 2. Bottom Line: Pension reform is highly likely to pass, if not as rapidly as its promoters say, and the Brazilian congress will soon need to turn to the next major item on the economic reform agenda. Tracking Bolsonaro’s Political Capital For The Post-Pension Reform Agenda Does Bolsonaro have enough political capital to pass other structural reforms? Or will he fall victim to stall speed as his policy focus shifts to less market-friendly areas, his relationship with the legislature breaks down, and his popular support continues to slide? With macroeconomic headwinds and a fragile governing coalition, the answer is a qualified yes that Bolsonaro has sufficient political capital to spend on additional reforms. But since it is impossible to know precisely what will occur after the pension reform goes through, we highlight the key signposts that we will use to monitor Bolsonaro’s progress. A fundamental premise is that neither Bolsonaro nor his party are instinctively or ideologically pro-market. He won the 2018 election due to a specific set of circumstances and popular policies. These form the four pillars of his political support: The Collapse Of The Left: The 2016 and 2018 elections wiped out the Worker’s Party, which had ruled Brazil since 2003, and swept Bolsonaro to power on a wave of deep disillusionment. The success of Bolsonaro’s right-wing Social Liberal Party (PSL), a decidedly minor party, over Fernando Haddad’s left-wing PT, one of the country’s biggest parties, highlighted Brazilians’ disenchantment after the worst recession in a century and a sprawling corruption scandal that implicated most of the political elite. Chart I-2The Left Is Still Wounded Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" While Bolsonaro’s “honeymoon period” after election has ended, the PT has not recovered from its loss of legitimacy over the past decade. A poll conducted in late August reveals that if the 2022 election were held today, Bolsonaro would secure a sizable lead not only over the PT but also over the combined opposition (Chart I-2). Pension Reform: All of Brazil’s political elites recognize that the bloated pension system must be cut back to improve the country’s fiscal profile and debt sustainability. After the previous government failed to do so, this became a central Bolsonaro campaign promise. Consensus on pension reform has enabled him to form a majority coalition; it is among the most popular items on the government’s agenda not because people love having their pensions cut but because of the widespread perception that it is necessary and will improve Brazil’s overall economic circumstances (Chart I-3). Chart I-3Brazilians See The Value In Pension Reform Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Ironically, however, passing this reform will also remove this pillar of the administration’s political capital. Bolsonaro will be left with less political capital to spend on other reforms and he will face less unity within his coalition having accomplished its greatest shared goal. Thus if the bill passes yet fails to boost his approval rating, or immediately prompts him to pursue less market-friendly policies or to lose major parties from his coalition, then it is a red flag suggesting that he is a one-trick pony and will not get other major reforms done in his term. Law And Order: Bolsonaro was elected on a ticket of restoring order. The crime rate has fallen since the beginning of the year and voters will be looking for this to be sustained (Chart I-4). The fall in the crime rate and the net approval of the security environment in Brazil are positive for Bolsonaro’s credibility. However, it is not clear that his policies are directly responsible for this improvement, which means the trend could change. If crime goes up, he loses political capital to do other things. Moreover the public may not approve of his approach. As indicated by Chart I-3 above, while the population is divided over the right to possess weapons in the home, there is clear disapproval of the right to possess weapons on the street. Pursuit of an unpopular solution could diminish his support on law and order. Chart I-4A Rise In Crime Would Hurt Bolsonaro Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Chart I-5Moro Key For Bolsonaro Anti-Corruption Drive Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Corruption: The third panel of Chart I-4 also reveals that combating corruption is a key area of perceived success by the Bolsonaro administration to date. Bolsonaro won the office partly because he was seen as a clean leader during a time of pervasive corruption. His administration is also fortified by the presence of Minister of Justice Sergio Moro, who played a leading role in prosecuting corrupt figures in the Lava Jato operation. Moro is by far the most popular minister in cabinet today (Chart I-5). A decline in Moro’s popularity would be an indication that Brazilians are not satisfied with the administration’s progress on the anti-corruption front. As such it would flag declining political capital. If Moro departs the administration for any reason, that would also hurt Bolsonaro's credibility on this critical issue. Bolsonaro’s approval rating to date is very low relative to previous presidents and falling (Chart I-6). The only way this can change is if he gets credit for the pension reform and then prioritizes policies that are broadly popular rather than ideological. As mentioned, the change in the wake of pension reform will be critical to observe: polls show that the public gives the federal government and President Bolsonaro personally the most credit for improvements in Brazil (Chart I-7), but it is not clear that he will be greatly rewarded for cutting pensions. Chart I-6Will Pension Reform Passage Save Bolsonaro? Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Chart I-7All Credit Goes To The Bolsonaro Administration Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed"   The legislative effort has succeeded largely due to House Speaker Rodrigo Maia, a clutch player in congress. The economic liberal Maia has set aside personal differences with the leadership to shepherd economic reforms through congress. This has involved a pragmatic approach that sidelines the president’s controversial social policies and focuses on getting pro-market bills passed. Chart I-8A Weak Starting Point For PSL Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" The political news flow from Brazil this year has been preoccupied with the rift between the legislative and executive branches. At first glance, congress looks impossible to navigate. As is typical in Brazil, congress is extremely fractured. Bolsonaro’s PSL holds only 10% of seats that belong to the 25 parties in the lower house, and only 5% of the seats that belong to the 17 parties in the upper house (Chart I-8). This is comparable to the first Cardoso administration – so it is not impossible to grow this legislative base – but it is a weak starting point. On top of that, Bolsonaro has held true to his campaign promise to shun so-called “old politics” – the granting of cabinet positions or “pork” based on congressional patronage. This reinforces his anti-corruption pillar but makes it hard to grease the wheels of legislation. The passage of the pension reform proposal through Brazil’s Chamber of Deputies shows that congress can be navigated, but it highlights Maia’s critical role. This relationship could break down after pension reform, which would reduce the government’s ability to accomplish additional reforms that require legislative approval. Maia’s third two-year term will expire at the end of next year. He technically cannot be elected for a successive term (although this rule has already been broken). This raises the threat that his successor may not be as pro-market or as successful in managing the lower house. In fact, the coming 12 to 18 months create a window of opportunity for the administration and legislature to pass bills before the 2020 local elections and the 2022 general election begin to interfere. Since the pension cuts will be back-loaded – delayed until subsequent years – voters will not immediately feel the pain of the social security changes, which will reduce the chances of a major popular backlash during this window. Provided Maia’s pragmatism continues to prevail, the government can use the pension reform to launch into another major reform initiative. Economy minister Paulo Guedes, another key pro-market player, has highlighted privatization and tax reforms as the next big issues on his agenda. The upcoming 12-18 months offer a window of opportunity for further reforms. Bottom Line: Tensions between the executive and legislative branches of government have not prevented pension reforms from passing because Bolsonaro had a fresh mandate, full political capital, and a broad consensus on the policy itself. Going forward a great deal of political capital will have been spent while consensus will have to be built for the next policy priority. House Speaker Rodrigo Maia is a clutch player, pragmatically enabling the passage of bills through congress, so his cooperation is essential. The upcoming 12-18 months offer a window of opportunity for further reforms, most notably privatization and tax reform. An Executive Way Forward On Privatization The administration’s privatization plan is overly ambitious but there is an executive path forward while the government enters a long slog in the legislature. Guedes has indicated that he wants to sell all of Brazil’s state owned enterprises to the private sector. In value terms, the government hopes to raise 1.3 trillion reals ($323 billion) in the process, about 20% of total public debt. Brazil has 418 SOEs controlled directly or indirectly by the state, both at the state and municipal levels. Of the 134 federal companies, 46 are under direct control, while the remaining 88 are under indirect control – subsidiaries of major SOEs such as Petrobras, Eletrobras, Banco do Brasil, Caixa, and BNDES. With Brazil’s public debt at 86% of GDP, profit from these sales would go toward paying down the debt and hopefully also raising GDP through gains from increased competition and efficiency. The program would also reduce the government’s interest payments – that account for 25% of government spending and 5% of GDP. Salim Mattar – Special Secretary of Privatization, Divestment and Market — argues that the interest saved will allow the government to divert funds to education and health, buoying Brazil’s human capital over the long term. The privatization of inefficient and loss-generating SOEs is positive for both the near-term and long-term outlook, but the government’s plan is completely unrealistic. Even Mattar’s significantly lower projected gains – up to 800 billion reals ($214 billion) – are likely unattainable. Although the government will easily meet its target of raising $20 billion this year,2 these sales represent the low-hanging fruit – they are the asset sales that face no or low resistance from the public and congress. On August 21, the Bolsonaro government released a list of 17 state-owned companies that it intends to privatize (Table I-1). From among the largest SOEs, – Petrobras, Eletrobras, BNDES, Banco do Brasil, and Caixa Economica Federal – only Eletrobras is on the list. The rest of the major SOEs will face greater hurdles as they have been identified as “strategic” and face greater resistance from the public (Chart I-9). In fact, although government officials expressed confidence that Eletrobras will be privatized in 2020, Senate President Davi Alcolumbre indicated that the process faces significant resistance in the senate. As such we would expect the legislature to tackle companies that are not as controversial. Table I-1Government Privatization List Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" What is more, while congressional approval is required for the sale of SOEs, a supreme court ruling earlier this year allows the government to sell subsidiaries of its companies without approval from congress. Thus while major state companies such as Petrobras or Eletrobras are unlikely to be privatized (certainly not wholly), the government will attempt to move forward by selling non-core assets of non-strategic companies, and taking other measures to improve efficiency of operations. Chart I-9These "Strategic" SOEs Face Privatization Resistance Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Chart I-10Privatization Will Reduce Debt Burden Privatization Will Reduce Debt Burden Privatization Will Reduce Debt Burden Putting aside the administration’s plan to accelerate the program next year, if we project $20 billion worth of privatizations per year for the remainder of Bolsonaro’s term, the total $80 billion in total sales will bring Brazil’s debt-to-GDP ratio down to 81% from 85% (Chart I-10). Bottom Line: Although the sale of the largest “strategic” state-owned companies will not happen, the administration’s privatization program can succeed by diverting congressional efforts to non-strategic companies. The administration can also move alone on non-core assets. This is a net positive for overall productivity, competitiveness, and fiscal sustainability although it is not huge in magnitude. Less Optimism On Tax And Tariff Reform In addition to the outsized economic role of the state, Brazil has been suffering from inefficiencies due to the relatively elevated tax burden and overly complicated system (Chart I-11). This has reduced its ranking in the World Bank’s Doing Business rankings which assigns it the seventh worst spot in paying taxes (Chart I-12). The nearly six thousand laws governing taxes in Brazil likely hold back the country’s FDI potential and encourages tax evasion. Chart I-11Brazilians Suffer From Outsized Tax Burden … Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Chart I-12… Contributing To An Unattractive Business Environment Brazil: Just Above "Stall Speed" Brazil: Just Above "Stall Speed" Given Brazil’s poor fiscal standing and large debt load, there is no room to reduce taxes. Rather, reform efforts are centered around simplifying the tax code in order to improve the investment environment. A complete overhaul requires the approval of three-fifths of congress. Pension reform shows this is theoretically possible, but the process will be lengthy and unlikely to occur before the second half of next year. There are currently four main proposals being considered. All aim to simplify the tax system by combining all current taxes imposed on consumption into a single tax. The proposal most advanced in the legislative process enjoys the support of Maia and has already been deemed lawful by a lower house committee. It recommends applying the single tax rate uniformly across all states. Bolsonaro’s administration is also designing its own reform proposals, but has yet to release details. As revealed by the firing of special secretary to Brazil’s federal revenue service Marcos Cintra on September 11, the cabinet is in conflict over the reintroduction of a financial transactions tax, such as the CPMF which expired in 2007. Chart I-3 above illustrates that the tax is generally unpopular, causing Bolsonaro to be staunchly against the tax, while Guedes has indicated that it should be part of the reform. The proposal is expected to be put to lawmakers in a congressional committee responsible for drafting the bill by October 8 before being introduced to the lower house. However, given that the financial transactions tax is unpopular and a point of contention in the administration, the timeline will likely be delayed. Moreover the legislative approval process will be lengthy. While Bezerra Coelho does not expect tax reform to be approved until the second half of 2020, this is an optimistic assessment. Given the complexity of overhauling the tax system, we expect a one-year process at minimum and therefore doubt that approval will come in 2020. Instead modifications to the current system may be easier to enact and implement. Guedes has also signaled the need for a reduction in Brazil’s extremely elevated import tariffs which have been erected amid a policy of import substitution (Chart I-13). With most tariffs in the range of 10% and 35%, Guedes has stated that the government plans to reduce tariffs by 10 percentage points during Bolsonaro’s four year term by cutting the rate by one percentage point in the first year, two in the second, three in the third, and four in the fourth. This can be done by executive action and does not require legislation. What about Bolsonaro's trade liberalization push? On the campaign trail, Bolsonaro expressed his intention to step back from Mercosur and instead prioritize bilateral trade with rich countries such as the United States. However, given the importance of the bloc to Brazilian trade, the reality is that Bolsonaro cannot afford to neglect these countries (Chart I-14). The recently agreed EU-Mercosur trade deal, 20 years in the making, could create opportunities for Brazil over the long-run, but it is being held up by European countries as appetite for free trade deals becomes politically problematic across the world. Chart I-13Elevated Tariff Rate Hurts Brazil's Competitiveness Elevated Tariff Rate Hurts Brazil's Competitiveness Elevated Tariff Rate Hurts Brazil's Competitiveness Chart I-14Trade Surplus With Mercosur Is Reliable Trade Surplus With Mercosur Is Reliable Trade Surplus With Mercosur Is Reliable While greater integration with global trade will increase Brazil’s market access – a positive for exports – it also results in increased competition and a threat to existing companies that are unable to compete at an international level over the near term. Thus it is not immediately clear whether trade liberalization will generate net gains for Brazil’s economy in the short term. If Bolsonaro and Guedes do not move immediately, they will have to pause these efforts in the 2021 lead up to the 2022 election. Moreover the Mercosur agreement, as well as Brazil’s general bilateral trade with Argentina, are at risk if opposition leader Alberto Fernandez wins the presidential election on October 27. A return to protectionist policies by Argentina could harm Brazilian exports and threaten progress on the Mercosur trade bloc. There is more reason to be optimistic about privatization than about tax reform or trade liberalization. Bottom Line: There is more reason to be optimistic about privatization efforts than about the passage of a major overhaul to Brazil’s tax system or the integration of Brazil with global markets. Nevertheless, ongoing efforts should sustain an improvement in “animal spirits” in the short term and create some potential for structural improvements over the long term. The Economy: A Stall Speed Risk Chart I-15A Slow Grinding Recovery A Slow Grinding Recovery A Slow Grinding Recovery The Brazilian economy is en route to recovery, albeit a slow one. The level of economic activity is still well below its pre-recession level but is grinding slowly back (Chart I-15). The key economic risk is stall speed. Like an aircraft, if the pace of growth falls below stall speed, gravity forces will overwhelm, and the economy will descend into a recession. In the case of Brazil, gravity forces refer to indebtedness – public debt, household debt servicing costs and corporate foreign currency debt. The path of least resistance for the business cycle is up and bullishness on Brazil is pervasive in the global investment community. Nevertheless, the economy remains very fragile. At the current juncture, while acknowledging that odds for the positive outlook to pan out are reasonably high, we would like to emphasize that gravity forces remain acute in Brazil. While odds for the positive outlook to pan out are high, gravity forces remain reasonably acute. Weakening narrow money growth fore shadows a weaker pace of nominal and real economic activity (Chart I-16). Brazilian households have increasingly relied on credit cards and revolving credit lines to finance their consumption in recent years. These types of credit carry high interest rates. Consequently, at 21% of disposable income, household debt servicing remains very elevated despite a large reduction in bond yields and policy rates (Chart I-17). Chart I-16Is Growth About To Stall? Is Growth About To Stall? Is Growth About To Stall? Chart I-17Household Servicing Costs Remain Elevated Household Servicing Costs Remain Elevated Household Servicing Costs Remain Elevated Private banks have experienced a modest uptick in non-performing loans (NPLs) (Chart I-18). This may incentivize private banks to moderate credit growth. With public banks deleveraging or shrinking their balance sheets, any moderation in private bank lending could stall the pace of growth in the economy. Interestingly, all-time low bond yields and the Selic rate have not yet translated into a meaningful recovery in real estate prices and new construction launches remain anemic (Chart I-19). Chart I-18Private Banks NPLs And Credit Growth Private Banks NPLs And Credit Growth Private Banks NPLs And Credit Growth Chart I-19Weak Property Market Despite Low Interest Rates Weak Property Market Despite Low Interest Rates Weak Property Market Despite Low Interest Rates   Fiscal policy is straightjacketed by the spending cap rule, which indexes government spending to the rate of inflation of the previous year. Nominal fiscal spending will grow only 4.3% this year and will expand by a mere 3.4% in 2020. Foreign debt obligations (FDO) – the sum of short-term claims, interest payments and amortization over the next 12 months – stand at $180 billion, equivalent to 78% of Brazil’s annual exports (Chart I-20).  The current account deficit will continue widening if domestic demand and, consequently, imports recover. Foreign funding requirements – FDO plus the current account balance – are substantial, standing at $250 billion (Chart I-21). If portfolio flows to EM are disturbed, Brazil will feel the pain. Chart I-20Foreign Debt Obligation Are Elevated Foreign Debt Obligation Are Elevated Foreign Debt Obligation Are Elevated Chart I-21Brazil Has Large Funding Gap... Brazil Has Large Funding Gap... Brazil Has Large Funding Gap... Chart I-22...With Exports Contracting ...With Exports Contracting ...With Exports Contracting With export growth contracting by double digits on both a value and volume basis (Chart I-22), the demand vesus supply of dollars in Brazil will likely keep the greenback well bid versus the Brazilian real. The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio. Bottom Line: The path of least resistance for the business cycle is up. However, the economy remains very fragile. A negative external or domestic shock could cause the Brazilian economy to stall speed. Barring such negative shocks, the economy will continue its recovery. Have Financial Markets Reached Escape Velocity? Financial markets are vulnerable to the risk of stall speed on both the structural reforms and economic growth fronts. This is especially true now that equity and bond prices have risen substantially. If the pace of structural reforms or the economy fall victim to stall speed, financial markets will tumble. On the contrary, if the reform agenda progresses and economic growth accelerates, financial markets will reach escape velocity and sustain their bull markets. Apart from the outlook for both structural reforms and the business cycle, the largest risks to Brazil’s financial markets are as follows: BCA’s Emerging Markets Strategy team expects base metals and energy prices to decline further, weighing on EM currencies. The main culprit is weakening Chinese demand. This scenario entails non-negligible odds of Brazilian real depreciation because the latter has historically been positively correlated with commodity prices (Chart I-23). Brazil has become a net exporter of oil, so lower crude prices are negative for the currency. Importantly, the real is not cheap based on the real effective exchange rate (Chart I-24). Chart I-23Commodity Prices Hold The Key Commodity Prices Hold The Key Commodity Prices Hold The Key Chart I-24Real Valuations Are Not Yet Attractive Real Valuations Are Not Yet Attractive Real Valuations Are Not Yet Attractive The gap between local currency and U.S. dollar bond yields has narrowed to a record low. This along with the large overhang of corporate foreign currency debt, as discussed above, is already encouraging debt swap - corporates borrow in reals to repay their foreign currency debt. These capital outflows from residents will continue weighing on the exchange rate. A widening current account deficit has historically foreshadowed lower share prices in U.S. dollar terms (Chart I-25). Finally, local bond yields, and sovereign and corporate spreads have plummeted despite currency depreciation. Such resilience by fixed-income markets to currency depreciation is historically unprecedented. It remains to be seen if yields and credit spreads can remain low if the currency breaks down. Bottom Line: Barring stall speed in structural reforms and economic growth, downside in Brazilian asset prices is limited. However, near-term volatility is likely as the nation’s financial markets are overbought and investor sentiment is very bullish. Besides, equity prices in dollar terms have not broken above important technical resistance levels, as shown in Chart I-26. Hence, we can say the bull market in the Bovespa in dollar terms has not yet reached escape velocity. Chart I-25The Current Account Is A Risk To Share Prices The Current Account Is A Risk To Share Prices The Current Account Is A Risk To Share Prices Chart I-26The Bovespa In Dollar Terms Has Not Reached Escape Velocity The Bovespa In Dollar Terms Has Not Reached Escape Velocity The Bovespa In Dollar Terms Has Not Reached Escape Velocity Investment Recommendations Weighing the pros and cons, we recommend upgrading Brazil from underweight to neutral for dedicated EM equity, credit and domestic bond portfolios. Given the potential risks discussed above, we are looking for a better entry point to upgrade Brazil to overweight. We upgraded Brazil to overweight on October 9, 2018 following the first round of presidential elections but downgraded it on April 4, 2019 when volatility began rising. In retrospect, that was the wrong decision. Volatility could rise but there is a basis for giving the administration the benefit of the doubt as long as it remains committed to pro-market reforms. Chart I-27Real Estate Stocks Offer An Opportunity bca.ems_sr_2019_09_27_s1_c27 bca.ems_sr_2019_09_27_s1_c27 For long-term absolute return investors the key risk is the exchange rate. Hence, these investors should adopt a positive long-term bias for local currency returns but hedge currency risk periodically. Currently, global financial markets are in a juncture where the dollar will likely move higher and the Brazilian real will depreciate. Hence, investors already invested in Brazil should hedge exchange rate risk. Within the Brazilian equity universe, BCA’s Emerging Markets Strategy service favors real estate because low nominal and real interest rates are bullish for the property sector. The latter was devastated during the recession and has not yet recovered (Chart I-27). Consequently, for long-term investors, we continue recommending Brazilian real estate plays/assets on dips. Footnotes   1      "Stall speed" is the velocity below which an aircraft will descend, or 'stall', regardless of its angle of attack. If an aircraft's airspeed is greater than the stall speed then the pilot can increase the aircraft's angle of attack to achieve additional lift. 2      So far in 2019 the government has already sold off $12.3 billion worth of assets from Petrobras, $4.9 billion in shares held in various companies, and gained $1.9 billion from leases on airports, railways and ports.

Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Bifurcated Equity Markets Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM Bifurcated Markets In EM Bifurcated Markets In EM   How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD bca.ems_wr_2019_09_05_s1_c3 bca.ems_wr_2019_09_05_s1_c3 Chart I-4EM And DM Commodity Currencies EM And DM Commodity Currencies EM And DM Commodity Currencies   Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks U.S. High-Beta Stocks U.S. High-Beta Stocks DM bond yields.  Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Korean Exports: No Recovery Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chinese Imports To Remain Weak Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German Manufacturing Confidence German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio bca.ems_wr_2019_09_05_s1_c9 bca.ems_wr_2019_09_05_s1_c9 Chart I-10Global Cyclicals Versus Defensives Global Cyclicals Versus Defensives Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 U.S. High-Beta Stocks Versus S&P 500 U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds EM Stocks Have Massively Underperformed U.S. Bonds EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile Continue Receiving Rates In Korea And Chile Continue Receiving Rates In Korea And Chile   We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Short EM Banks / Long EM Consumer Staples Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight EM Credit / Overweight U.S. Investment-Grade Corporates   Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling  further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating The Economy Is Deteriorating The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth Narrow Money Points To Negative Growth Narrow Money Points To Negative Growth   An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve A Message From The Inverted Yield Curve A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Fiscal Policy Has Tightened A Lot Fiscal Policy Has Tightened A Lot   Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Local Bond Yields And Relative Stocks: Mexico Versus EM Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse Consumer Staples Have A Large Weight In Mexican Bourse Consumer Staples Have A Large Weight In Mexican Bourse   We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Investors Are Long MXN Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Take Profits On Long MXN / Short ZAR Trade Take Profits On Long MXN / Short ZAR Trade   Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Four ghosts of 2016 are knocking at the door: Brexit, Trump, Brazil, Italy. President Trump and U.S. trade policy are keeping uncertainty high. Upgrade the odds of a no-deal Brexit to about 33%. Expect limited stimulus from Italy and Germany – for now. Brazil’s pension reform is entering its final stretch – buy the rumor, sell the news. Feature Four major political events of 2016 are returning to affect the global investment landscape this fall – though only two of these ghosts are truly frightening. In order of market relevance: Trump: The election of Donald J. Trump as U.S. president, November 8, 2016 Brexit: The U.K. referendum to leave the European Union, June 23, 2016 Italy: The Italian constitutional referendum, December 4, 2016 Brazil: The removal of Brazilian President Dilma Rousseff, August 31, 2016 Italy and Brazil are producing market-positive political results in the short run. Brexit and Trump pose substantial and immediate risks to the global bull market. A pivot by Trump is the headline risk to our view that no trade agreement will be concluded by November 2020, as we outlined in a Special Report last week. At the moment tensions are still escalating. President Trump has ordered an increase in tariffs (Chart 1) and threatened to invoke the International Economic Emergency Powers Act of 1977, which would give him the ability to halt transactions, freeze funds, and appropriate assets. China is retaliating proportionately and virtually incapable of softening its tone prior to its National Day celebration on October 1. The next round of negotiations, slated for Washington in September, could be a flop like the talks in July, or it could be canceled. Investors should stay defensive. The equity market will have to fall to force Trump to stage a tactical retreat. Meanwhile China could intervene violently in Hong Kong SAR. That possibility, the nationalist military parade on October 1, and U.S. actions toward the South China Sea and Taiwan, show that sabers are rattling, causing additional market jitters. Chart 1Trump's Latest Tariff Salvo Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 U.S.-China tensions underpin our tactical safe-haven trade recommendations. But we are not shifting to a cyclically bearish stance until we get clarity on Trump’s and Xi’s handling of their immediate predicament. Brexit is the other acute short-term risk. This was true even before Prime Minister Boris Johnson opted to prorogue parliament from September 10 to October 14, shortening the time that parliament has to either pass a law forbidding a no-deal exit or bring down Johnson’s government in a vote of no confidence. We are upgrading the odds of “no deal” to no higher than 33%, using a conservative decision-making process (Diagram 1). No-deal is not our base case because parliament, the public, and even Johnson himself want to avoid a recession, which is the likely outcome, even granting that the Bank of England will not stand idly by. We are upgrading the odds of “no deal” Brexit to about 33%. Diagram 1Brexit Decision Tree (Revised August 29, 2019) Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 From a bird’s eye point of view, the pound is very attractive (Chart 2). But in the near-term the twists and turns of Britain’s political struggle imply that we will see wild volatility. Our foreign exchange strategists expect that a no-deal Brexit would cause GBP/USD to collapse to 1 after October 31. Assuming our one-in-three odds of such an outcome, the probability-weighted average of cable is about 1.2. Hence investors should not short sterling from here, unless they strongly believe we are underrating the odds of no-deal exit. In the worst-case scenario, a no-deal Brexit will cause an economic shock at a time when Europe is on the brink of recession – Italy and Germany are virtually there. This means there is a substantial risk of additional deflationary pressure piling onto German bunds and sustaining the global bond rally. This pressure will be sharply reduced if Johnson loses an early no confidence vote, but that is a 50/50 call so we would not call time on this rally yet. Stay cautious. Chart 2Pound Can Only Go So Low Pound Can Only Go So Low Pound Can Only Go So Low   Italy: Stimulus … Without A Bruising Brussels Battle Italy has avoided a new election by producing an unusual tie-up between the establishment Democratic Party and the anti-establishment Five Star Movement (M5S). The coalition still needs to clear some internal hurdles and an online vote by Five Star members, but an agreement is to be presented to President Sergio Mattarella as we go to press. This is the most market-friendly outcome that could have been expected, as is clear through the sharp drop in Italian government bond yields (Chart 3). Our GeoRisk indicator for Italy is also collapsing. Chart 3Markets Cheer New Italian Coalition Markets Cheer New Italian Coalition Markets Cheer New Italian Coalition This development marks the climax of a story line that we outlined in 2016, when Prime Minister Matteo Renzi lost a constitutional referendum that aimed to strengthen Italian governments to enable deeper structural reforms (he subsequently resigned). At that time we argued that Italy would emerge as a market-relevant political risk due to rampant anti-establishment sentiment, but that this risk would subside when Italy’s populists were shown to be pragmatic at heart, i.e. unwilling to push their conflicts with Brussels to a point that truly reignited European break-up risk. This view is now vindicated – and not only for the short-term. The new coalition comes at the nick of time, with Europe teetering on recession and the risk of a no-deal Brexit rising. The new government will have to deliver the 2020 budget to the European Commission by October 15. The budget will aim to provide fiscal support, including a delay of the legislatively mandated hike in the Value Added Tax from 22% to 24.2%, already rolled over from 2019. The Five Star Movement will demand as a price for its participation in the coalition that social spending go up; the Democratic Party will have learned a lesson while out of power and will be more fiscally permissive and strike a tougher tone with Brussels. The Italian budget talks will be a non-issue: the coalition will cooperate with Brussels. The episode demonstrates that the Italian risk to financial markets is overrated. This point goes beyond the fact that the Democrats and Five Star were able to cooperate. Italy’s leading populist parties have already shown that they are pragmatic and will play the game with Brussels to avoid a financial breakdown. In May 2018, the newly formed populist coalition proposed a gigantic “wish list” budget that would have increased the budget deficit to roughly 7.3% of GDP in 2019. They also appointed a euroskeptic economy minister who almost prevented government formation. The ensuing conflict with Brussels triggered considerable turmoil (Chart 4). Ultimately, however, the populists did precisely what we expected: they bowed to the severe financial constraint on Italy’s banking system. They agreed to a 2019 and 2020 deficit of 2.04% and 2.1%, respectively (Chart 5). Chart 4Italian Populists Prove Pragmatic Italian Populists Prove Pragmatic Italian Populists Prove Pragmatic Chart 5Even Salvini Compromised On Budget Clash Even Salvini Compromised On Budget Clash Even Salvini Compromised On Budget Clash At present, the market is relieved that an election was avoided that might have seen Salvini and the League form a government with a much smaller right-wing party (Fratelli D’Italia) (Chart 6) – but the truth is that Salvini had already capitulated to the EU, both on budget matters and the euro currency. He was hardly likely to push for a budget more aggressive than that of the initial proposal in 2018. The clash with Brussels would have been a flash in the pan; the result would have been greater fiscal thrust, which would have been market-positive in the current environment. Chart 6Election Would Have Meant More Stimulus ... And More Political Risk Election Would Have Meant More Stimulus ... And More Political Risk Election Would Have Meant More Stimulus ... And More Political Risk M5S will also push for more spending and has also moderated their stance on the euro. A coalition with the Democrats will not work if the purpose is to push a euroskeptic agenda. There will be a focus on counter-cyclical fiscal policy, pragmatic reforms that the two can agree on, and fighting corruption. The budget talks will be a non-issue: the Democratic Party is an establishment party and the coalition will cooperate with Brussels. Furthermore, the context has changed since 2018 in a way that will reduce budget frictions. There is a need for countercyclical fiscal policy in light of the global slowdown, so the European Commission will have to be more flexible on the budget. This is particularly true if Germany itself loosens its belt on a cyclical basis. The risk to the above is that the coalition shaping up between the Democrats and Five Star is an alliance of convenience that will break down over time. Five Star will remain hard-line on immigration, which is driving anti-establishment sentiment. Italian elections are a frequent affair. Salvini and the League will be waiting in the wings, especially if Brussels proves too tight-fisted or if the Democrats do not toughen their stance on immigration. But as outlined above, Salvini’s own evolution on the euro, on northern Italy, and on the budget and financial stability shows that the economy will have to get a lot worse before Italian euroskepticism presents a renewed systemic risk. Bottom Line: The tentative coalition taking shape in Italy will produce a modest increase in fiscal thrust with minimal frictions with Brussels. As such it is the most market-friendly outcome that could have occurred from Salvini’s push to seize power. Beneath this episode of government change is the political arrangement taking shape in Italy, and across Europe, which calls for a commitment to the European project and currency. The price of this commitment is a tougher line on immigration from European leaders. Germany: Fiscal Loosening, But Not For The States (Yet) Our GeoRisk indicator for Germany is pointing to an increase in risk in recent weeks. Germany is threatened by a potential technical recession and while fiscal stimulus is in preparation, there will not be a fiscal game-changer until Merkel steps down in 2021 – barring a total collapse in the economy that forces her hand in the meantime. The outlook is not improving (Chart 7, top panel). The economy shrank by 0.1% in Q2 2019, exports are falling, and passenger car production is at the lowest level ever recorded (Chart 7, bottom panels). Chart 7German Economy Gets Pummeled German Economy Gets Pummeled German Economy Gets Pummeled Chart 8Germany: Expect Orthodox Stimulus For Now Germany: Expect Orthodox Stimulus For Now Germany: Expect Orthodox Stimulus For Now Finance Minister Olaf Scholz has announced that Germany could increase government spending by $55 billion within the context of European and German budget constraints. Split proportionally between 2019 and 2020, this additional spending would not put Germany in violation of the “black zero” rule – a commitment to a balanced budget that limits the federal structural deficit to 0.35% of GDP – even without any additional revenue (Chart 8).   There will not be a fiscal game-changer in Germany until Merkel steps down – barring a crisis. The German Chancellery reports that it does not see the need for stimulus in the short term – as long as trade tensions do not escalate and there is no hard Brexit. At present, however, trade tensions are escalating and the odds of a no-deal Brexit are increasing. Moreover China’s economy and stimulus efforts continue to disappoint. In this context Germany’s ruling coalition is putting together a climate change package that would entail additional spending (while stealing some thunder from the increasingly popular Green Party). Given the European Commission’s forecast of Germany’s 2020 budget surplus, 0.8% of GDP, the government could ultimately go further than Scholz’s ~$50bn. This is because the black zero rule provides for exceptions in case of recession (or natural disasters or other crises out of governmental control) with a majority vote in the Bundestag. Hence we are not so much concerned about the magnitude of the stimulus as its timing. First, Merkel and her coalition typically move slower than the market would like in the face of financial and economic challenges. Second, according to the black zero rule, which is transcribed in the German constitution (the Basic Law), the Länder cannot run budget deficits from 2020. Amending the constitution to delay this deadline requires a two-thirds majority in the Bundestag and the Bundesrat – a much taller order than the simple majority needed to boost federal deficits. The governing coalition currently holds 56% of the seats in the Bundestag. If the Greens were brought on board, which they would be inclined to do, this number falls just short of two-thirds at 65.6%. In order to obtain a two-thirds majority in the Bundesrat, the Social Democrats, Christian Democrats, and the Greens would need the support of another party, either the Left or the Free Democrats. This could be done but it would require political will, which is only likely to be sufficient if the German and global economy get worse from here. Meanwhile financial markets will have to settle for the gradual implementation of a stimulus package on the order of 1% of GDP – the one the government is planning. Bottom Line: While Germany will likely roll out a stimulus package by Q4, if third quarter GDP data confirm that the country is in a technical recession, Merkel’s hesitation and budget limits mean that this stimulus will likely be moderate. A marginal upside surprise is possible but it will not represent a true “game changer” on fiscal policy in Germany. The game changer is more likely after Merkel steps down in 2021. The Green Party is surging in Germany and could possibly lead the next government. Even if it doesn’t, its success and Europe-wide developments are pushing German leaders to become more accommodative. Brazil: Reform Or Bust Political turmoil in Brazil over the past five years has ultimately resulted in a right-wing populist government under President Jair Bolsonaro. Bolsonaro is pursuing a pension reform that is universally acknowledged as necessary to straighten out Brazil’s fiscal books, but that the previous government tried and failed to pass. On this front the news is market-positive: having cleared the lower Chamber of Deputies, the pension reforms are now likely to pass the senate. This will lift investor confidence and give Bolsonaro an initial success that he may then be able to translate into additional economic reforms. The Brazilian economy and financial markets are moving in opposite directions. The currency and equities staged a mid-year rally despite negative data releases – shrinking retail sales and industrial production amid high unemployment (Chart 9). More recently these assets relapsed despite tentative signs of improvement on the economic front (Chart 10). All the while, chaos and controversies surrounding Bolsonaro’s government have weighed on his approval rating, ending the honeymoon period after election (Chart 11). Chart 9Brazil: Signs Of Improvement Brazil: Signs Of Improvement Brazil: Signs Of Improvement   Chart 10Brazil: Markets Sold Despite Pension Progress Brazil: Markets Sold Despite Pension Progress Brazil: Markets Sold Despite Pension Progress Chart 11Bolsonaro’s Honeymoon Is Long Gone Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 The mid-year equity re-rating was driven by an improvement in sentiment on the back of the government’s pension reform. The relapse occurred despite the passage of the pension reform bill in the lower house, indicating that global economic pessimism has dominated. The bill’s next step goes to the senate where it faces two rounds of voting before enactment (Diagram 2). It should clear this hurdle by a large margin, though we expect delays. Diagram 2Brazil: Pension Reform Timeline Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 In the second round vote in the lower house on August 6 – which had a smaller margin of victory than the first round – deputies voted largely in line with party alliances (Charts 12A & 12B). Assuming legislators in the senate behave in the same way, the reform should gain the support of 64 of the 81 senators – easily surpassing the 49 votes needed. Even in a more pessimistic scenario where all opposition parties and all independent parties vote against the bill – along with two defecting senators from government-allied parties – the reform would pass by 56-25. Chart 12APension Bill Sailed Through Lower House ... Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Chart 12B... And Should Pass Senate In Time Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 This favorable outlook is also supported by popular opinion, which indicates that the majority of those polled agree that pension reforms are necessary (Chart 13). This leaves two questions: How soon will the bill clear the senate? According to senate party leaders’ proposed timetable, the bill will undergo its first upper house vote on September 18 with the second round slated for October 2. This is ambitious. The strategy of Senator Tasso Jereissati – who has been appointed senate pension reform rapporteur – is to approve the text in its current form and create a parallel proposed amendment to the constitution (PEC) which will bring together the amendments that senators make to the original text. Dozens of amendments have been filed with the Commission on Constitution and Justice. These will prolong the enactment of the final bill and dilute its impact. We doubt the senate will let Jereissati have his way entirely and hence expect delays and dilution. Chart 13Brazil: Public Now Favors Pension Reform Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Chart 14Brazil: Pension Reform Not Enough Brazil: Pension Reform Not Enough Brazil: Pension Reform Not Enough How much savings will the bill generate? Will the reforms be sufficient to improve public debt dynamics in Brazil? The Independent Fiscal Institute of the senate estimates that the reform will generate BRL 744 billion of savings. This is significantly less than the BRL 1.2 trillion initially proposed, and lower than the BRL 860 billion that Economy Minister Paulo Guedes has indicated as the minimum fiscal savings required. Our Emerging Markets strategists argue that the bill falls short of what is needed. While the plan will reduce the fiscal deficit and slow debt accumulation, it will be insufficient to generate primary surpluses over the coming years (Chart 14).1 Moreover, estimated savings in the final bill will likely be further revised down as the bill undergoes more amendments in the senate. What comes after pension reform? The market has focused almost exclusively on this issue to the neglect of Bolsonaro’s wider economic reform agenda. The agenda includes privatization, trade liberalization, tax reforms, and deregulation. Here we are more skeptical. First, Bolsonaro will have spent a lot of political capital on pensions. Second, while the economy and unemployment are always important, they are not the foremost concern for Brazilians (Chart 15). Chart 15Bolsonaro Will Lose Political Capital After Pension Bill Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Third, the economic agenda is often at odds with Bolsonaro’s social, foreign, and environmental policies: The new Mercosur-European Union trade agreement and ongoing trade negotiations between Mercosur and Canada are positive developments. However the G7 summit in France highlighted that the deal with the EU is at risk due to dissatisfaction with Bolsonaro’s response to the Amazon fires. France and Ireland have threatened to withhold support of the ratification. With world leaders concerned about the political risks of trade liberalization, and with Trump having issued a license to foreign leaders for trade weaponization, an escalation of tensions between the Europeans and Bolsonaro could lead to punitive measures even beyond the delay to the Mercosur-EU deal. Brazil’s China problem: Bolsonaro has been cozying up to President Donald Trump while striking a more aggressive tone with China. This is a risky strategy as it may undermine Brazil’s economic interests. The country’s exports are much more leveraged to China than to the U.S. and have been benefitting on the back of the trade war as China substitutes away from the U.S. (Chart 16). The president’s planned trip to China in October reveals an attempt to mend ties after having accused China of dominating key Brazilian sectors during his election campaign. But it is not clear yet that Bolsonaro will stage a retreat. And if President Trump backtracks on his trade war in order to clinch a deal, Bolsonaro may have lost some goodwill with China without receiving the benefit of China’s substitution effects. Hence Bolsonaro will have to soften his approach to China to make progress on the trade aspect of the reform agenda. Chart 16Brazil: Time To Mend Ties With China Brazil: Time To Mend Ties With China Brazil: Time To Mend Ties With China Bottom Line: We expect the passage of a diluted pension reform bill that will slow the growth of public debt to some extent. However global headwinds are persisting. And any success on pensions should not be extrapolated to other items on the economic reform agenda. Bolsonaro’s trade liberalization faces difficulties on the surface. Other domestic reforms are even more difficult to achieve in the wake of painful pension cuts. Reforms that enjoy public support and do not require a complicated legislative process are the most likely to be implemented, but even then, legislation and implementation are likely to be long-in-coming in Brazil’s highly fractured congress. As a result we share the view with our Emerging Markets Strategy that the pension reform is a “buy the rumor, sell the news” phenomenon. Housekeeping We are booking gains on our long BCA global defense basket for a 17% gain since inception in October 2018. The underlying thesis for this trade remains strong and we will reinstitute it at an appropriate time, though likely on a relative basis to minimize headwinds to cyclical sectors. We are also finally throwing in the towel on our long rare earth / strategic metals equity trade. The logic behind the trade is intact but it was very poorly timed and the basket has depreciated 24% since inception.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see BCA Research’s Emerging Markets Strategy Weekly Report “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. France: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 U.K.: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Germany: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019   Italy: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Spain: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Russia: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019   Korea: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Taiwan: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Turkey: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Brazil: GeoRisk Indicator Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 What's On The Geopolitical Radar? Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Four Ghosts Of 2016 - GeoRisk Update: August 30, 2019 Geopolitical Calendar

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth bca.ems_wr_2019_08_22_s1_c3 bca.ems_wr_2019_08_22_s1_c3 Chart I-4China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. Chart I- The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract Philippine Exports Will Contract Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Philippine Equities Are Expensive Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation The Exchange Rate And Inflation The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? A Top In The Business Cycle? A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Severe Fiscal Tightening Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking The Business Cycle Is Peaking The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Things Could Get Worse Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations