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Dear Client, In lieu of our regular report next week, we are sending you a Special Report from my colleague Chester Ntonifor, Foreign Exchange Strategist. Chester will share his outlook on the Hong Kong Dollar. I hope you will find his report insightful. Please note that next week’s report will be published on Friday, August 21. Best regards, Jing Sima, China Strategist   Highlights President Trump's ban of China-based apps marks a new front in the Sino-US tech war. There is no change in our strategic views. The impact on both China’s aggregate economic growth outlook and the financial markets should be limited on a cyclical basis. Consider overweight Chinese offshore ex-TMT stocks and onshore semiconductor stocks within a global equity portfolio, against a backdrop of escalating hostilities in the tech sphere. Feature Chart 1Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Geopolitical risks again stirred up volatility last week in China’s equity markets. President Trump issued two executive orders to take effect in 45 days, banning US transactions with the Chinese-owned social media apps TikTok and WeChat. Shares in Tencent, the China-based Internet giant that owns WeChat, have plummeted by 11% in China’s offshore market following the ban announcement (Chart 1). The event underscores that technology is at the root of a power struggle between the US and China. The struggle will likely be exploited by Trump as the US presidential election nears and Trump’s polling numbers lag. However, we remain constructive on Chinese stocks over the next 6 to 12 months.  Although the latest development remains highly fluid, the tensions should not have a material impact on the cyclical outlook for China’s aggregate economy or financial markets. This will be the case as long as the situation does not degenerate into an outright tariff increase on Chinese export goods or other strategic actions with the potential to cause major economic damage.  Given rising downside risks to Chinese tech company stocks in the near term, we recommend investors hold a neutral position on Chinese tech giant company equities versus their global peers. Instead, investors should overweight Chinese “old economy” stocks as well as sectors that are greatly benefited from policy support. We initiate two trades today: long MSCI China ex-TMT versus MSCI Global ex-TMT;1 and long domestic semiconductor stocks versus global semiconductor benchmark. A New Front In Tech War It is likely that the US will implement the ordered bans in some way. Banning TikTok wasn’t a surprise because the US had amply signaled its displeasure with the app in preceding months. The social media company has rapidly gained US market share and hence access to American users’ data. Its parent company ByteDance is based in Beijing and therefore subject to China’s cybersecurity laws, a major source of bilateral tensions. The company originated in a Chinese acquisition of an American company, another irritant for the Trump administration. The US is now pressuring TikTok’s US operations to sell the app to an American-based company such as Microsoft. Regarding Trump’s executive order on WeChat and Tencent, it is not clear what “transactions” with Tencent will be disallowed from the US market.2 Additionally, US officials later appeared to backpedal and limit the scope of the executive order on Tencent to only the WeChat app. We have a few preliminary observations on the evolving situation: It is unknown how far the executive action will go regarding Tencent. The Internet titan gets less than 5% of its revenues from outside China, according to its 2019 financial statement.  However, Tencent has many prominent investments in the US gaming and music industries. The US Commerce Department has 45 days to interpret and enforce the directive. The vague language in the executive order provides the US with enough legal space to deprive Tencent of US technologies in those sectors, and would severely curtail Tencent’s online gaming business, which is its main engine of growth. The bans underscore the US administration’s intention to extend tech hostilities with China by denying Chinese tech companies the access to compete and expand globally. Last week, Secretary of State Mike Pompeo announced a five-pronged “Clean Network” initiative that would scrub Chinese companies from US telecommunications networks entirely.3 China, for its part, has been progressively banning US social media giants since 2009. China has not announced any retaliatory actions since the executive orders were issued. Top Chinese policymakers seem to have shifted gears from a tit-for-tat retaliation to a carefully calibrated diplomatic reaction that does not ramp up tensions further. Moreover, there is a sizeable contingent of top Chinese policymakers pushing for reconciliation with the US. We think that China’s senior leaders prefer to dial down the current conflict and take a wait-and-see approach until after the US presidential election in November. Nevertheless, the next two to three months will be unpredictable as the election nears and Trump’s polling numbers lag behind his rival Joe Biden. Bottom Line: China’s leading Internet and tech companies are embroiled in a US-China feud. Pressures will likely intensify with other tech companies potentially also targeted. For now, stay neutral on leading Chinese tech company stocks within a global equity portfolio. Stick With The Knowns Chinese tech company stock prices will likely be extremely volatile in the short run. Nevertheless, we are staying the course with our constructive cyclical view on overall Chinese stocks and we do not recommend any one-way bets on the market during the next two to three months. China’s financial markets have been shaken by negative surprises relating to frictions with the US.  However, investors cheer on even the slightest easing of tensions between the two countries. Last Friday’s volatile trading was a good example: initial confusion over the ban’s scope in Trump’s order led to a more than 10% plunge in Tencent stock during morning trading in the Hong Kong market, but the losses were cut in half after the US indicated the ban only affected the WeChat app. Chart 2Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Economic policy support from the Chinese government and “national team” can also distort the short-term price trend in tech equities. These stocks have risen by more than 20% in both the onshore and offshore markets since the beginning of 2018, despite the deteriorating US-China relationship (Chart 2). While we are neutral on tech company stocks, we recommend overweight Chinese “old economy” stocks and remain constructive on domestic sectors that are beneficiaries of government policy support. We are initiating two trades: long MSCI China ex-TMT versus MSCI Global ex-TMT; and long domestic semiconductor stocks versus global semiconductor benchmark. The reflationary efforts since early this year facilitated a strong rebound in China’s industrial sector activities and profits (Chart 3). In turn, China’s ex-tech "old economy" stocks have outperformed relative to their global peers. Even though the handful of tech titans account for roughly 35% of the investable market capitalizations, MSCI China stock prices excluding tech titans have decisively broken out of their 200-day moving average, which suggests there is still sufficient support to our constructive view on the overall investable index (Chart 4). Chart 3Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Chart 4Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Our cyclical overweight view on China’s domestic stocks also remains unchanged. The domestic market is much more sensitive to the trend in monetary conditions, credit growth and economic cycles than the investable market. As we pointed out in last week’s report,4 monetary conditions are accommodative and credit and economic growth remain in an uptrend. This underscores that China’s domestic stocks have more upside potential than investable stocks, even in an escalating geopolitical risk environment. Chart 5Chinese Semis Are On Fire Chinese Semis Are On Fire Chinese Semis Are On Fire Lastly, more pressure from the US and the West to curb the advancement of Chinese technology will only encourage the leadership to double down on supporting state-led technology programs. This argues for a more bullish view on Chinese tech companies that focus on the domestic market, at least on a cyclical basis (Chart 5). Last week the State Council updated its policy, supporting two strategically important sectors: integrated circuits and software. The central government has had policies in place to support these two sectors since 2000 and updates its support policies every decade or so. Last week's updated version will allow chip companies to enjoy even more tax exemptions and favorable financing than the first set of support policies. China has clearly stepped up its promotion of self-sufficiency and redoubled  its efforts to thwart any pressures meant to restrain its technological progress.  As pointed out by our Geopolitical Strategy team,5 the U.S. and its allies control 95% of the global semiconductor market (Chart 6). Nonetheless, China is the world’s largest importer, accounting for about one-third of global semiconductor sales, making it the largest consumer of semiconductors (Chart 7). Chart 6China’s Chip Makers Are Still Small Fry Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 7China Accounts For 60% Of Global Semiconductor Demand Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 8Made In China 2025 Targets Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War In brief, China relies a lot on imported semiconductors and is working to mitigate this dangerous vulnerability. The Made in China 2025 program estimates that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Bottom Line: China’s domestic industrial sector will continue to recover in the next 6 to 12 months. The nation’s semiconductor industry will get a boost from recently shored-up government policy supports. Overweight these sectors in the face of expanding tensions from the US tech war against China.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1TMT stocks include information technology prior to December 2018, and include media & entertainment and internet & direct marketing retail sectors after December 2018. 2Please see the orders: https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-tiktok/ and https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-wechat/ 3https://www.state.gov/announcing-the-expansion-of-the-clean-network-to-safeguard-americas-assets/ 4Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated August 5, 2020, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Dear clients, This week we are sending you a Research Note on balance of payments across the G10, authored by my colleague Kelly Zhong. With unprecedented monetary and fiscal stimulus, balance-of-payment dynamics will become an even more important driver of currencies over the next few years. That said, while the US current account is in deficit, the short dollar narrative is beginning to capture investor imagination, suggesting the call is rapidly becoming consensus. We are in the consensus camp, but are going short GBP today, as a bet on a short-term reversal. As for cable, the recent rally has gotten ahead of potential volatility in the coming months, even though it is cheap. Finally, we are lowering our target on the short gold/silver trade to 65, but tightening the stop-loss to 75. I hope you find the report insightful. Chester Ntonifor, Vice President Foreign Exchange Strategy Highlights COVID-19 has turned the world upside down this year, and severely impaired global trade. Global trade values plunged by 5% quarter-on-quarter in the first quarter, and are forecasted to have slumped by 27% in the second quarter. Most countries have also seen negative foreign direct investment (FDI) growth in the first few months of 2020. Global FDI inflows are forecasted to fall by 40% this year and drop by an additional 5-10% next. While all countries have been hit by COVID-19, the economic damage appears particularly pronounced in countries heavily reliant on foreign funding. Feature COVID-19 has turned the world upside down in 2020. The global economy headed into recession following a decade-long expansion. While many economies are starting to ease restriction measures, the possibility of a second wave remains a big downside risk to the global economy. If history is any guide, the Spanish flu during the early 1900s came in three waves, the second of which brought the most severe damage. Undoubtedly, international trade has been under severe pressure this year. Global trade volumes plunged by 5% in the first quarter, and are expected to be down 27% in the second quarter from their levels in the final three months of 2019. Moreover, the path of recovery remains uncertain as the pandemic continues to disrupt global supply chains and weaken consumer confidence. According to the United Nations Conference on Trade and Development (UNCTAD), it may take until late 2021/early 2022 for global trade to recover to pre-pandemic levels (Chart 1). As reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19.  Global FDI inflows rebounded in 2019, reaching a total of $1.5 trillion, as the effect of the 2017 US tax reforms waned and US repatriation declined. This year, however, most countries have seen negative FDI growth rates in the first few months in 2020. According to UNCTAD, global FDI inflows are forecast to plunge by 40%, bringing total FDI inflows below the US$1 trillion level for the first time since 2005 (Chart 2). Unfortunately, as reinvested earnings make up more than half of total FDI, squeezed earnings this year will have a direct impact on FDI in the aftermath of COVID-19. Typically, FDI flows bottom only six to 18 months after the end of a recession. FDI inflows are forecast to decline further by another 5-10% in 2021. Chart 1Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Steep Decline In Trade Volumes In 1H'20 Chart 2Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 Global FDI Projected To Fall Through 2021 While all economies have been hit by COVID-19, the impact varies by region. Emerging market countries, particularly those linked to commodities and manufacturing-intensive industries, appear to be have been hit harder by the crisis. This makes sense, given trade is much more volatile than services or consumption. Chart 3 shows that while exports make up less than 30% of GDP in the US, they amount to over 130% of GDP in Thailand and Malaysia, and over 300% of GDP in Singapore and Hong Kong. Chart 3Reliance On Trade Differ Across Countries Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 Going forward, the recoveries might be uneven as well. Prior to COVID-19, global trade flows were already facing many challenges, including trade disputes, geopolitical tensions and rising protectionism. COVID-19 may have just supercharged two megatrends: Technology and Innovation: The pool of investments concentrated on exploiting raw materials and cheap labor is shrinking, while those promoting technology and ESG are becoming crucial. De-globalization: Policymakers in many countries are promoting more regulation and intervention, especially in key industries related to national security and health care. This suggests COVID-19 might represent a tipping point, making balance of payments all the more important for currencies, as investors become more discerning between countries and sectors with a high return on capital and those without. The euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses.  In this report, we look at the balance-of-payment dynamics in the G10. The most important measure for us is the basic balance, which takes the sum of the current account and net long-term capital inflows. Our rationale is that these tend to measure the underlying competitiveness of a currency more accurately than other balance of payment measures. On this basis, the euro area, Switzerland, Australia and Sweden sport the best basic balance surpluses. The US is the worst (Chart 4). Below, we visit some of key drivers behind these trends. Chart 4Basic Balances Across G10 Balance Of Payments Beyond COVID-19 Balance Of Payments Beyond COVID-19 United States Chart 5US Balance Of Payments US Balance Of Payments US Balance Of Payments The US basic balance is deteriorating again (Chart 5). The key driver has been a decline in foreign direct investment. If this trend continues, this could further undermine the US currency. The US remains the world’s largest FDI recipient, attracting US$261 billion in 2019, which is almost double the size of FDI inflows into the second largest FDI recipient – China – with US$141 billion of inflows last year. However, cross-border flows have since fallen off a cliff after the waning effect of the one-time tax dividend introduced at the end of 2017. The lack of mega-M&A deals has also been a contributing factor. The trends in the trade balance have been flat, despite a push by the Trump Administration to reduce the US trade deficit and rejuvenate the US economy. The most recent second-quarter data show a deterioration from -2.3% of GDP to -2.8%. The trade deficit with China did drop by 21% to $345 billion in 2019, however, US companies quickly found alternatives from countries that are not affected by newly imposed tariffs, particularly from Southeast Asia: The US trade deficit with Vietnam jumped by 30%, or $16.3 billion, in 2019. More recently, exports have plunged much faster than imports, further widening the US trade deficit. On portfolio flows, the most recent TIC data show that US Treasurys continued to be shunned by foreigners in May. In short, the US balance-of-payment dynamics are consistent with our bearish dollar view. Euro Area Chart 6Euro Area Balance Of Payments Euro Area Balance Of Payments Euro Area Balance Of Payments A rising basic balance surplus has been one of the key pillars underpinning a bullish euro thesis. Of course, an apex in globalization will hurt this thesis, but the starting point for the euro area is much better than many of its trading partners. The trade surplus in the euro area was not spared from COVID-19 – it plunged to €9.4 billion in May from €20.7 billion the same month last year, as the pandemic hit global demand and disrupted supply chains. Exports tumbled by 29.5% year-on-year to €143.3 billion while imports declined by 26.7% to €133.9 billion. Even in this dire scenario, the trade surplus still remains a “healthy” 1.8% of GDP, buffeting the current account (Chart 6). Foreign direct investment inflows have regained some ground in recent years, with the improvement accelerating in recent months. FDI inflows surged by 18% in 2019, reaching US$429 billion. Outflows also rose by 13% in 2019, led by a large increase in investment by multinationals based in the Netherlands and Germany. Going forward, FDI is sure to drop, but this will not be a European-centric problem. Portfolio flows have started to reverse, but have not been the key driver of the basic balance. This is because ever since the European Central Bank introduced negative interest rates in 2014, portfolio outflows have been persisted. This also makes sense since Europeans need to recycle their excess savings abroad. In sum, despite the headwinds to global trade and investment, the basic balance remains at a healthy 2.9% of GDP, which bodes well for the euro. Japan Chart 7Japan Balance Of Payments Japan Balance Of Payments Japan Balance Of Payments A key pillar for the basic balance in Japan has been the current account balance, which has been buffeted over the years by income receipts from Japan’s large investment positions abroad. Going forward, this could make the yen very attractive in a world less reliant on global trade. Japanese exports tumbled by 26.2% year-on-year in June, led by lower sales in transport equipment, motor vehicles and manufactured goods. However, the slowing export trend was well in place before the pandemic. Exports had been declining for 18 consecutive months before COVID-19 dealt the final blow. Imports also fell by 14% year-on-year in June, led by lower energy prices. On the service side of the income equation, foreign visitors to Japan dropped by 99.9% from over 2.5 million in January to less than 2,000 in May. That equates to about 2% of the Japanese population. Despite all this, Japan still sports a healthy current account surplus, at 4% of GDP (Chart 7). In 2019, Japan remained the largest investor in the world, heavily recycling its current account surplus. FDI outflows from Japanese multinationals surged by 58% to a record US$227 billion, including US$104 billion in cross-border M&A deals. Notable mentions include Takeda acquiring Shire (Ireland) for US$60 billion, and SoftBank Group acquiring a stake in WeWork (the US) for US$6 billion. In terms of portfolio investments, foreign bond purchases have eased of late as global interest rates approach zero. Higher real rates are now being found in safe-haven currencies like the Swiss franc and the Japanese yen, which is supportive for the yen. Overall, the basic balance in Japan is at nil, in perfect balance between domestic savings and external investments. United Kingdom Chart 8UK Balance Of Payments UK Balance Of Payments UK Balance Of Payments The key development in the UK’s balance-of-payment dynamics is that a cheap pound combined with the pandemic appear to have stemmed the decline in the trade balance. The UK has run a current account deficit each year since 1983. This has kept the basic balance mostly negative (Chart 8). That could change if the marginal improvement in trade is durable and meaningful. The current account deficit further widened to £21.1 billion, or 3.8% of GDP, in the first quarter, of which the goods trade balance was more volatile than usual. Since May, the goods trade balance has been slowly recovering to £2.8 billion, but has been offset by the services trade deficit. The primary income deficit also widened in the first quarter as offshore businesses rushed to preserve cash buffers. Foreign direct investment in the UK has been improving of late, currently sitting at 3.7% of GDP. This is encouraging, given the steep post-Brexit drop. Going forward, we continue to favor the British pound over the long term due to its cheap valuation. However, we are going short today, as a play on a tactical dollar bounce. More on this next week.       Canada Chart 9Canada Balance Of Payments Canada Balance Of Payments Canada Balance Of Payments The Canadian basic balance has been flat for over a decade, as the persistent current account deficit has continuously been financed by FDI inflows and portfolio investment (Chart 9). This is a vote of confidence by investors over longer-term returns on Canadian assets. Canada is one of the largest exporters of crude oil, meaning the fall in resource prices generated a big dent in export incomes. However, the country is slowly on a recovery path. Exports increased 6.7% month-on-month in May, helping narrow the trade deficit to C$0.7 billion. More importantly, a positive net international investment position means that positive income flows into Canada are buffeting the current account balance. In 2019, Canada was the 10th largest FDI recipient in the world, with FDI inflows increasing to US$50 billion. Today, the basic balance stands at a surplus of 1% of GDP.               Australia Chart 10Australia Balance Of Payments Australia Balance Of Payments Australia Balance Of Payments Australia’s trade balance has been rapidly improving since the 2016 bottom, and has been the primary driver of an improving basic balance. While exports fell as the pandemic hit a nadir, imports fell more deeply. This allowed the trade surplus to widen in the first six months of the year compared to last year. Australia has long had a current account deficit, as import requirements to help drive investment opportunities were not met by domestic savings. With those projects now bearing fruit, the funding requirement has greatly eased. This has buffeted the current account balance, which turned positive for the first time last year following a 35-year-long deficit, and continues to rocket higher (Chart 10). Going forward, Australia’s trade balance and current account balance are likely to continue increasing as Australia has a comparative advantage in exports of resources, especially LNG, which is consistent with the ESG megatrend. Australia is also introducing major reforms to its foreign investment framework to protect national interests and local assets from acquisitions. Meanwhile, net portfolio investment remains negative, suggesting the current account surplus is being recycled abroad. In short, we believe the Aussie dollar has a large amount of running room, based on its healthy basic balance surplus of 4% of GDP. New Zealand Chart 11New Zealand Balance Of Payments New Zealand Balance Of Payments New Zealand Balance Of Payments Compared to its antipodean neighbour, the New Zealand basic balance has been flat for many years, but has seen recent improvement (Chart 11). The trade balance was boosted by goods exports, which were up NZ$261 million, while imports were down NZ$352 million in the first quarter of this year. The rise in goods exports was led by an increase in fruit (mainly kiwifruit), milk, powder, butter and cheese. More recently, due to the ease of lockdown measures, exports increased by 2.2% year-on-year in June while imports marginally rose by 0.2%, further enhancing New Zealand’s trade balance. The primary income deficit widened to NZ$2.2 billion in the first quarter due to less earnings on foreign investment. Moreover, the secondary income deficit also widened, driven by a smaller inflow of non-resident withholding tax. Despite this, the current account deficit narrowed to NZ$1.6 billion in the first quarter, or 2% of GDP, the smallest deficit since 2016.  New Zealand received $5.4 billion in FDI flows in 2019, rising from only $2 billion in 2018. Most FDI inflows arrived from Canada, Australia, Hong Kong and Japan. Impressively, according to the World Bank’s 2020 Doing Business Report, New Zealand ranked first out of 190 countries due to its openness and business-friendly economy, low levels of corruption, good protection of property rights, political stability and favorable tax policies. Portfolio investment inflows also increased by NZ$11.8 billion.  The improvement in the backdrop of New Zealand’s basic balance will allow it to outperform the US dollar. As a tactical trade, however, we are short the kiwi versus the CAD. The basis is that relative terms of trade favor the CAD for now. Switzerland Chart 12Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland Balance Of Payments Switzerland’s basic balance is almost always in surplus, driven by a structural uptrend in the trade balance (Chart 12). This has allowed the trade-weighted Swiss franc to outperform on a structural basis. We expect this trend to continue. As a country consistently running high surpluses, Switzerland also tends to invest more in foreign assets. Over the years, these smart investments have helped buffet the current account. Overall, in the first three months of this year, the current account balance stood at CHF 17.4 billion, or 11.2% of GDP. In terms of the net international investment position, both stocks of assets and liabilities fell by CHF 110 billion and CHF 42 billion, respectively in the first quarter, due to falling equity prices globally. The net international investment position fell by CHF 67 billion to CHF 745 billion in the January-March period. That said, Switzerland continued to deploy capital abroad in the first quarter, which should help buffet the current account going forward. The positive balance-of-payment backdrop has created a headache for the Swiss National Bank. As such, the SNB will likely continue to intervene in the foreign exchange markets to calm appreciation in the franc. We believe the franc will continue to outperform the USD in the near term, but underperform the euro.  Norway Chart 13Norway Balance Of Payments Norway Balance Of Payments Norway Balance Of Payments Norway has a very open economy, with trade representing over 70% of GDP, and it has been hit quite hard by COVID-19 this year. The trade surplus started to plunge sharply due to falling energy prices at the beginning of the lockdown (Chart 13). More recently, Norway posted its first trade deficit in May since last September, which carried over to June, as exports fell more than imports. Thanks to increases in income receipts from abroad, the current account balance remained flat at NOK 66.1 billion in the first quarter. With persistent current account surpluses, Norway has long been a capital exporter. However, the FDI outflow and inflow gap is gradually closing. In 2019, net FDI was -3.5% of GDP. In the first quarter of this year, it was -3.3%. Portfolio outflows have also softened over the years, as the current account balance has narrowed. There was, however, a trend change in the first three months of this year - Norway’s purchases of foreign bonds, surged as investors switched to safer assets. Ultimately, we remain NOK bulls due to its cheap valuation. As economies gradually reopen and ease lockdown measures, the recovery in energy prices will push the Norwegian krone back toward its fair value.     Sweden Chart 14Sweden Balance Of Payments Sweden Balance Of Payments Sweden Balance Of Payments Sweden maintained its trade surplus with the rest of the world throughout the first few months of 2020 (Chart 14). Imports fell more than exports amid the pandemic. The goods trade balance almost doubled from the fourth quarter of 2019 to SEK 68.8 billion in the first quarter of 2020. The primary income surplus also increased by SEK 10 billion to SEK 42.2, further strengthening the current account and bringing the total current account surplus to SEK 80.6 billion, or 4% of GDP. Both FDI inflows and outflows have been increasing in Sweden, but the net number was slightly negative. In the first quarter of 2020, FDI inflows rose by SEK 51.6 billion while FDI outflows increased by SEK 100.6 billion. In terms of portfolio investment, Swedish investors reduced their portfolio investment abroad by SEK 141 billion in the first quarter, while foreigners decreased their portfolio investment in Sweden by SEK 45.8 billion. In conclusion, the Swedish krona remains one of our favorite longs due to its increasing basic balance surplus (4% of GDP) and its cheap valuation. We are long the Nordic basket (NOK and SEK) against both the euro and the US dollar. Kelly Zhong Research Analyst kellyz@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights A buildup in industrial inventory may temporarily slow down China’s commodity imports over the next month or two. Last week’s Politburo meeting stated that policy supports will remain in place for 2H20, despite a rising policy rate. We think the policy rate normalization will not imminently reverse the credit impulse; strong bank lending growth will be sustained and fiscal support will likely accelerate through Q3. The liquidity-driven hype in Chinese equities may be waning, but improving economic fundamentals should support a continued bull run (in both absolute and relative terms) for the rest of this year. Feature July’s official PMI indicates that China's economic recovery remains two-tracked, with a rebound in the supply side outpacing demand and investment outpacing consumption. This uneven improvement in the economy may lead to some inventory buildup in July and August. Nevertheless, both production and demand have grown steadily and should continue to pick up in the rest of the year, ahead of other major economies.1 The annual mid-year Politburo meeting last week indicates that the monetary and fiscal policies will remain accommodative through the end of 2020.  Chinese policymakers also emphasized the importance of reviving domestic demand and consumption in H2. While we have seen a rising interbank rate since late April, the current growth in credit should be sustained at least through Q3. Moreover, we expect fiscal spending to accelerate in H2 and boost infrastructure investment growth even higher. The authorities’ stringent regulations on equity margin lending may curb speculation in the financial markets. However, stronger economic fundamentals in the second half of 2020 bodes well for China’s equity performance, particularly for cyclical stocks on a 6-12 month time horizon. Tables 1 and 2 present key developments in China’s economic and financial market performance over the past month, and we highlight several developments below: Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 1Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) China’s official manufacturing PMI rose to 51.1 in July, beating the market consensus. The export order subcomponent of the PMI rebounded substantially last month, although it remains below the 50 percent boom-bust threshold (Chart 1). Recent high-frequency data in the US suggests that America’s economic and consumption recovery may be stalling.2 While weak economic improvement in major global economies will be a drag on external demand for consumer and capital goods, we expect that China’s export growth will continue to be supported by the pandemic-related need for medical supplies. Both the production and demand subcomponents of the PMI improved in July, but the demand side was outpaced by the supply side. This has led to a significant uptick in the finished-goods inventory subcomponent, which is the first advance in four months (Chart 2).  The acceleration in post-lockdown construction activity in Q2 and exceptionally low commodity prices have driven up China’s imports of major commodities, such as steel, copper and crude oil. In turn, industrial inventories remained at their highest levels since late 2017 (Chart 3). This suggests that an inventory destocking and delay in construction activity in the flood-stricken southern part of China may hold back commodity import growth in August and possibly September. Chart 2Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Chart 3High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 Chart 4Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Despite this, any moderation in China’s imports should be temporary. Industrial profit growth sprung back sharply in June. Rejuvenated growth in China’s industrial profits is crucial for fixed-asset investment and demand for durable goods, which would allow imports of commodities to remain robust in most of H2 this year (Chart 4). Statements from the mid-year Politburo meeting highlighted that “monetary policy will be more flexible and targeted in 2H20; and that the PBoC will focus on guiding the loan primary rate (LPR) lower to reduce financing costs for enterprises, particularly to the manufacturing sector and the SMEs.”  Since late April, the 3-month SHIBOR (the de facto policy rate) has been rising, though it remains at a historic low. Our take is that the authorities intend to normalize liquidity conditions in the interbank system, at least for the time being, to curb financial institutions’ speculative activities (Chart 5). Even though the rising policy rate has pushed up both government and corporate bond yields, it does not necessarily lead to an imminent tightening in credit growth. Instead, we expect bank lending and fiscal spending to accelerate. Even if the 3-month SHIBOR decisively bottomed in April, the momentum in credit growth should continue through Q3 and possibly peak in October (Chart 6). Our view is based on the following:  Chart 5Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Chart 6...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy   The rising policy rate and corporate bond yields do not seem to affect the amount of corporate bonds being issued. Moreover, corporate bond issuance as a share of total social financing has been flat since 2016 and remains small relative to bank lending (Chart 7, top and middle panels)   On the other hand, the local government bonds’ share of total social financing has been rising since 2016 (Chart 7, middle panel). Since the amount of local government bonds issued is set at the annual National People’s Congress, a rising policy rate and bond yields have little effect on this segment of total social financing. Last week’s Politburo meeting called for local governments to speed up their special purpose bonds (SPB) issuance and complete the 3.75 trillion yuan annual quota by the end of October. The government bond issuance in July was dominated by special COVID-19 relief treasury bonds (STB), therefore, the SPB issuance will be concentrated in August to October. Based on our estimates, the average SPB issuance may reach 500 billion yuan per month in August through October, a more than 30% increase from the average monthly issuance in H1 this year.   The largest share in total social financing is bank lending, which has not correlated with the policy rate since 2016 (Chart 7, bottom panel). Instead, bank loan growth and lending rates are affected by the LPR, which rate policymakers vow to guide further downwards (Chart 8). Additionally, the PBoC signaled that bank lending in 2020 is targeted at 20 trillion yuan. This leaves the second half of 2020 with a minimum of 40% of the target, or 8 trillion yuan of newly increased bank lending. To complete this annual target, according to our calculations, the growth rate of bank lending in 2H20 will need to reach at least 13% on an annual basis. This would equal to the annual growth in bank lending seen in H1. Chart 7Fiscal Support Will Accelerate Fiscal Support Will Accelerate Fiscal Support Will Accelerate Chart 8Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower China’s domestic and investable stocks dropped by 2% and 4%, respectively, from their peaks in early July, a technical correction that was mainly driven by market concerns that Chinese policymakers will withdraw stimulus too soon. China’s policymakers have indeed tightened interbank liquidity conditions and adopted more stringent measures to curb speculative behavior in the financial markets. However, we think the strong credit growth and fiscal stimulus will continue in the second half of the year, and will provide substantial support to boost China’s economic growth. As shown in Chart 9 (top panel), there has not been a steady correlation between China’s policy rate and equity performance. Rather, economic fundamentals are still the main driver for stock performance on a cyclical basis (6-12 month) (Chart 9, bottom panel). The multiples in Chinese stocks are not too elevated compared with their global peers (Chart 10A,10B, and 10C). Moreover, Chinese cyclical stocks have outperformed defensives, enhancing our cyclical bullish view on stocks in both absolute and relative terms (Chart 11).  Chart 9Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chart 10AChinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chart 10BChinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chart 10C...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers Chart 11Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Global Investment Strategy Outlook "Third Quarter 2020 Strategy Outlook: Navigating The Second Wave," dated June 30, 2020, available at gis.bcaresearch.com 2Please see Daily Insights "A Bumpy Recovery, But Stocks Have Room To Run," dated July 31, 2020, available at bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Tech Bubble Amid Tech War Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward China Political Risk Still Trending Upward China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Blue Wave Odds Rising, Equities Hesitate Blue Wave Odds Rising, Equities Hesitate Chart 2COVID-19 Outbreak Still A Risk Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 9Biden Would Re-Regulate The Economy Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Health Insurers Would Be Undercut By Biden's Public Option Health Insurers Would Be Undercut By Biden's Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps Big Pharma Faces Price Caps Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Profit Margin Drivers Profit Margin Drivers Chart 18Spot Trump's Tax Cut Spot Trump's Tax Cut Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. Table 1What EPS Hit To Expect? Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table 2S&P 600/S&P 500 Sector Comparison Table Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Not Everyone Is A Fan… Not Everyone Is A Fan… Chart 21...Of The Blue Sweeps ...Of The Blue Sweeps ...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Mind The Divergence Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End Beginning Of The End Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? How Much Is Too Much? How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme? Will History Rhyme? Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table A2Biden Would Spend $6 Trillion In Programs Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.  

Dear Client, In lieu of our regular report next week, I will present our view on China’s economic recovery, geopolitical risks, and implications on financial markets in two live webcasts. The webcasts will take place next Wednesday, July 15 at 10:00AM EDT (English) and at 9:00PM EDT (Mandarin). Best regards, Jing Sima, China Strategist Highlights China’s economic recovery continues through June, but the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009. The intensity of the PBoC’s monetary easing may start to taper in H2, but the central bank is likely to stay on the easing course and keep liquidity conditions ample. Bank lending to the corporate sector should increase further in H2. Chinese stocks rallied through last week’s enactment of the new national security law for Hong Kong and the subsequently announced sanctions from the US government. The existing US sanctions should have limited impact on Hong Kong and mainland China’s economies and financial markets. We remain positive on Chinese stocks despite the recent rallies in China’s equity markets. Feature June’s official and Caixin manufacturing PMIs indicate that China’s economic recovery continues at a steady rate, with the production side of the economy picking up slightly faster than the demand side. The drag on China’s economic recovery from lackluster demand growth should be temporary. Unlike in 2015 when policy uncertainties hindered the recovery in both economic activity and stock prices, the Chinese government has been determined to support its economy and job market in the current cycle. The massive stimulus implemented since March has tremendously boosted activities in China’s construction sector. While households and the corporate sector remain reluctant to spend and to invest, their marginal propensity to spend usually catches up with credit growth with about a 6-9-month lag (Chart 1). The sharp pickup in credit growth should meaningfully support China’s economic rebound, while a better global growth outlook in H2 should also provide some modest tailwinds. On June 30, the PBoC announced a 0.25 percentage point cut to its relending rates for small and rural enterprises and to its general rediscount rate. While the scale of rate cuts in H2 will unlikely match that of Q1, China’s monetary and fiscal policy support will remain in place through the rest of the year. Chinese investable and domestic equities were some of the best performers among global asset classes in June, whereas they were the third-worst the month prior (Chart 2). In the first week of July, both Chinese investable and domestic stocks rallied even further. As we noted in our last week’s report,1 China’s stronger economic outlook, less uncertainty related to its domestic COVID-19 containment, and policy support should provide more room for Chinese stocks to trend upwards. Last week’s passing of the new national security law for Hong Kong and the subsequently announced sanctions from the US government, in our view, should have limited impact on investors’ sentiment for now. Chart 1China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months China's Household And Corporate Marginal Propensities Lag The Credit Impulse By 6-9 Months Chart 2Chinese Equities Are Taking Flight China Macro And Market Review China Macro And Market Review   Tables 1 and 2 present key developments in China’s economic and financial market performance in the past month, and we highlight several of these developments below: Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review China’s June official manufacturing PMI ticked up to 50.9 from 50.6 in the previous month. The Caixin manufacturing PMI came in at 51.2, beating the expectation of 50.5 and compared to 50.7 in May. Both suggest that China’s manufacturing sector continues to expand, however the pace of its demand-side recovery has been more muted compared to the V-shaped rebound in 2009 (Chart 3). Although the import and export subcomponents have fared better in June from the low levels in April and May, their readings in June were still below the 50 boom-bust line (Chart 4). Headwinds remain strong for global trade as the US and many of emerging economies are still struggling with the pandemic. Even without re-imposing lockdowns, the resurge in the number of new cases in the US may result in a drag on consumption and global trade. The IMF projects a 12% contraction in global trade in 2020. While the external demand may improve in H2, positive contribution to China's GDP growth from the net exports will be limited this year. Chart 3Current Recovery Lies Somewhere Between 2009 And 2015 Current Recovery Lies Somewhere Between 2009 And 2015 Current Recovery Lies Somewhere Between 2009 And 2015 Chart 4Demand-Side Recovery Remains Muted Demand-Side Recovery Remains Muted Demand-Side Recovery Remains Muted   The employment situation in the manufacturing sector has worsened since May, and has returned to contraction following a brief improvement in March and April (Chart 5). An estimated 8.7 million new graduates in 2020,2 a historical high number, will hit the job market in July and August. As such, China’s labor market will likely remain under significant pressure. Even though employment usually lags economic recoveries, depressed expectations on the job market will refrain policymakers from prematurely withdrawing stimulus measures. Small and micro enterprises are an important part of China’s private sector, which provides 80% of jobs in China. The manufacturing PMI of small enterprises fell below the 50 boom-bust line in June, reflecting a persistent weakness in this part of China’s economy. The recent relending and rediscount rate cuts suggest that the PBoC is committed to stay on the easing course. The intensity of monetary easing may start to taper in H2, but the central bank is likely to keep liquidity conditions ample and encourage banks to accelerate lending to the corporate sector. The contraction in Chinese producer prices deepened to -3.7% (year-over-year) in May. However, we think PPI deflation is likely to bottom in Q3. Both the purchasing and producer price subcomponents of the manufacturing PMI ticked up sharply in June, while the drawdown in industrial product inventory relative to new orders has accelerated (Chart 6). The ongoing accommodative policy should provide powerful tailwinds to both economic activity and the PPI in H2. The improvement in the PPI will help to boost industrial profits growth, which turned positive in May (year-over-year) for the first time this year. We expect year-to-date industrial profits to end the calendar year with a modest positive growth rate.  Chart 5Labor Market Pressure Intensifies Labor Market Pressure Intensifies Labor Market Pressure Intensifies Chart 6PPI Deflation Nears Its Bottom PPI Deflation Nears Its Bottom PPI Deflation Nears Its Bottom   China’s property market indicators have notably trended up in May, with year-over-year growth in housing demand normalizing to its pre-pandemic level (Chart 7A & Chart 7B). As the demand in housing rebounded faster than the supply, housing prices have correspondingly turned the corner in May after trending down for 6 consecutive months. Chart 7AHousing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Housing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Housing Prices Ticked Up Slightly Following A Sharp Fall In Q1 Chart 7BStrong Rebound In Property Investments Strong Rebound In Property Investments Strong Rebound In Property Investments   Chart 7B shows that housing investments and land purchases have also recovered to near their pre-pandemic levels. Financing restrictions for property developers that were put in place since 2018 have been loosened in H1, which helped to boost real estate investments. We expect the property sector financing conditions to remain accommodative through the rest of this year. Moreover, there is a possibility that the PBoC will lower the 5-year MLF (medium lending facility) rate in Q3. As downward pressures on China's labor market and household income growth intensify, the government is likely to lower the mortgage rate to ease payment constraints on households. Chart 8Chinese Stocks Rallied Through Frictions Over Hong Kong Chinese Stocks Rallied Through Frictions Over Hong Kong Chinese Stocks Rallied Through Frictions Over Hong Kong Despite the passing of China’s new and controversial national security law for Hong Kong on June 30 and the subsequently announced sanctions from the US government, stock prices in both China’s onshore and offshore markets rallied (Chart 8). While we agree the US may impose further and more concrete sanctions on China during the months leading up to the November US presidential election, our preliminary assessment points to a limited economic cost on China from the existing US sanctions. The removal of Hong Kong’s special trade status will subject Hong Kong’s export goods to the same tariffs the US levies on Chinese exports. But the raised tariffs will barely make a dent in Hong Kong or mainland China’s export status quo. Hong Kong’s economy consists mainly of the financial, logistical and services sectors. The manufacturing sector only accounts for 1% of its overall economy. Chart 9 shows that Hong Kong’s exports to the US only accounted for around 1% of its total exports and 1.3% of its GDP in 2019. More importantly, of the $5 billion goods Hong Kong exports to the US, only 10% is actually produced in Hong Kong. Most of Hong Kong's exports to the US are goods produced in China that are re-exported through Hong Kong, which are already subject to the same tariffs as the goods China exports to the US directly.3 On the other hand, US exports to Hong Kong accounts for 2% of its total exports, with a trade surplus of about $30 billion in the past two years (Chart 9, bottom panel). The US trade surplus with Hong Kong has drastically reduced since the US-China trade war broke out in 2018, suggesting that the US has already imposed restrictions on its export goods to mainland China through Hong Kong. Moreover, the large trade surplus with Hong Kong as well as China’s commitment to the Phase One trade deal may be part of the reason President Trump is unwilling to impose more substantial sanctions on China right now. The US senate and house have also passed a bill which, if signed and implemented by President Trump, will allow the US government to levy any foreign financial institutions for knowingly conducting business with individuals who are involved in jeopardizing Hong Kong’s autonomy. Chinese banks with operations in the US will be mostly exposed to such sanctions. However, Chinese banks are largely domestic-focused with very low reliance on foreign-currency funding (Chart 10). Hence, the direct impact of a deteriorating operating environment in the US will be limited on Chinese banks. Chart 9Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Trade Sanctions On Hong Kong Exports Have A Minimum Impact On Its Local Economy Chart 10Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors Chinese Banking Sector Stock Performance Is Largely Driven By Domestic Policy Factors   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report "Upgrading Chinese Stocks To Overweight," dated July 1, 2020, available at cis.bcaresearch.com 2 iiMediaReport, Analysis report on current situation and development trend of Chinese employment entrepreneurship market in 2020. 3 Please see Nicholas Lardy, “Trump’s latest move on Hong Kong is bluster”. Peterson Institute For International Economies, dated June 1, 2020.   Cyclical Investment Stance Equity Sector Recommendations

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

  Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 5Trump’s Lifeline Is The Economy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Market At Risk Of Election Cycle Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced European Risks Are Getting Priced European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 18Egypt Is Militarily Capable … On Paper Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Volatility And Mediterranean Quarrels (GeoRisk Update) Volatility And Mediterranean Quarrels (GeoRisk Update) Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict Position For An Escalation In The US-China Conflict   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Our recalibrated model suggests that, if President Trump places a 25% tariff on all Chinese goods exports to the US, then the RMB should fall by 4% against the dollar from its current value. The RMB has been trending below its “fair value” in the past two years, but as US-China tensions escalate, the PBoC will likely allow the market forces to push the RMB lower. We continue to hold a long position in the USD-CNH, but recommend investors keep the position on a short leash. The key risk to this view is a broad-based dollar weakness. So far, the yuan has been resilient against a dramatic drop in the DXY. The more that the RMB deviates from its fair value, the more rapidly and strongly it could appreciate in the absence of further tariff hikes. Feature The strong probability of a re-ignited US-China trade war this year will place the RMB under downward pressure against the USD.1 Unlike in 2019 when China was trying to reconcile with the US to reach a trade deal, this year President Trump will encounter a much less compromising President Xi Jinping. Therefore, it is more likely that Beijing will use depreciation as a countervailing tool on, and even ahead of any additional tariffs on Chinese goods exports to the US.   The RMB would likely fall by 4% if the US was to boost import tariffs to 25% on all Chinese goods. We recalibrated our Equilibrium Exchange Rate Model to project the tactical (0-3 months) fluctuations in the RMB against the dollar, in different scenarios of tariff hikes. If President Trump is to raise the tariff rate to 25% on all US imports of Chinese goods, the RMB should fall by 4% against the dollar from its current value. On a cyclical time horizon (the next 12 months), however, the RMB will likely rebound. The RMB has been trending below its fair value against the dollar since the onset of the trade war in mid-2018, but the economic fundamentals that supported the dollar’s strength in the last two years have diminished. Even if a second wave of the Covid-19 pandemic materializes, but does not result in severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth continues to recover. The combination of a stronger global economy and weaker dollar should help strengthen pro-cyclical currencies, such as the RMB. A Recalibrated Model Based On The Economics Of Tariffs If the US were to impose further tariffs on Chinese exports, how much will the RMB fall against the dollar? According to our recalibrated Equilibrium Exchange Rate Model, if the US was to boost import tariffs to 25% on all Chinese goods tomorrow, then the RMB would likely fall by 4% to around 7.35 against the dollar2 (Chart 1A and 1B). That said, currency markets tend to undershoot, and market forces will likely push the RMB lower on the prospect of further escalation. More importantly, the PBoC will be less likely to lean against this weakness, since the lower in the exchange rate will buffet exports. Chart 1AUSDCNY Under Tariff Rate Hike Scenarios USDCNY Under Tariff Rate Hike Scenarios USDCNY Under Tariff Rate Hike Scenarios Chart 1BA Tariff Timeline The Evolution Of The US-China Trade War A Tariff Timeline The Evolution Of The US-China Trade War A Tariff Timeline The Evolution Of The US-China Trade War Tariff hikes typically catalyze an adjustment between two countries: either in the exchange rate to realign price competitiveness, in the quantity of tradeable goods, or a combination of the two.  Chinese goods exports to the US have only modestly decreased in the past two years from the pre-trade war year of 2017. Given that global trade has been mostly slowing since then, it signifies that the adjustment has largely occurred through the exchange rate (Chart 2). For a perfectly open economy, standard economic theory suggests that the exchange rate should move by the same percentage as the tariff increase to allow markets to clear. However, both the US and China do not have perfectly open economies. This suggests that the currency adjustment needed should be smaller.3 For example, as of 2019 only 16.7% of Chinese exports go to the US. A 25% tariff on all of these exports will lift overall export prices by only 4.2% (16.7*25%). This does not even take into consideration export substitution, and/or other factors that will influence tradeable prices. Chart 2Chinese Exports To The US Did Not Drop Much... Chinese Exports To The US Did Not Drop Much... Chinese Exports To The US Did Not Drop Much... Chart 3...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency ...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency ...Mainly Because China "Paid For" The Tariffs By Depreciating Its Currency Therefore, we recalibrated our model to reflect the assumed increases in both Chinese export prices and US import prices, rather than the pure increase in the US tariff rates. We also assumed that China will bear the brunt of the costs from the tariff hikes, which appears to have been the case in the past two years (Chart 3). The projections for where the USD/CNY rate is likely to settle in the next 0-3 months have closely tracked movements in the currency since July 2018. A Cyclical View On The RMB The RMB has depreciated by about 12% versus the dollar from its peak in April 2018, a non-trivial move for a currency that has been tightly managed. Rapid depreciations in the past two years have changed the valuation perspective of the RMB. Compared with our fair value estimates, the RMB has been undervalued in both real effective exchange rate terms and against the dollar. Chart 4The RMB Is Undervalued In Real Effective Terms... The RMB Is Undervalued In Real Effective Terms... The RMB Is Undervalued In Real Effective Terms... Our revamped Equilibrium Exchange Rate Model concludes that existing tariff rates should have the USD-CNY settle at around 6.98.  Currently, USDCNY is close to 7.1, suggesting that the market has been pricing in the risk of the US raising tariffs on China.  This means in the absence of further tariff hikes, the RMB will rebound and revert towards its fair value. Moreover, the RMB in real effective exchange rate terms has been undervalued compared with our fair value estimate, which is based on China's relative productivity trends and real bond yield differentials (Chart 4). With a 10-year bond in China yielding 2.8%, versus 0.7% in the US, interest rate differentials are likely to continue to structurally favor the RMB. Against the dollar, the RMB is also undervalued based on our relative purchasing power parity (PPP) models (Chart 5). Our PPP models make two crucial adjustments for an apples-to-apples comparison. First, the CPI baskets are broken into five subcomponents including food, shelter, health, transportation and household goods. Second, we run two regressions, one using the relative price ratios of the five subgroups (regression 1), and another using an aggregated price index weighted symmetrically across both the US and China (regression 2).4 Chart 5...And Against The Dollar ...And Against The Dollar ...And Against The Dollar Chart 6The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation The PBoC Is Taking A More "Laissez-Faire" Approach Towards The RMB Depreciation It is true that valuation rarely matters in the near term and the market almost always over- or under-shoots from its "fair value" levels. The strength in the USD since early 2018 has also played a dominant role in the RMB’s depreciation. However, the RMB’s spot exchange rate has deviated from its fundamental equilibrium in the past two years. In contrast with the previous cycle, the PBoC does not appear to have intervened heavily in the offshore market to prevent excessive currency weakness. For example, in 2015/2016, the PBoC heavily clamped down on outflows. Offshore HIBOR rates also spiked, which is widely viewed as the PBoC's attempt to maintain exchange rate stability and to punish speculators by dramatically squeezing RMB liquidity in the offshore market. This time around, the PBoC is taking a more “laissez-faire” approach even though the RMB is weaker than back then (Chart 6). The key message is that longer-term investors should use RMB weakness to accumulate long positions, as any tariff-related weakness will cheapen an already attractive currency. Investment Conclusions In the near-term, a flare-up in the US-China trade war could trigger investors’ risk-off sentiment and economic fundamentals could be temporarily put aside. We continue to recommend a long position in the USD-CNH. Nevertheless, the more that the RMB deviates from its fair value, the more rapidly and strongly it will reverse to its fundamental equilibrium when tensions ease between the nations. The sharp reversal in the USD-CNY spot rate in the past three weeks illustrates this view (Chart 7). Thus, we recommend investors keep the long USD-CNH position on a short leash. Chart 7CNY/USD Below Its Long-Term Trend CNY/USD Below Its Long-Term Trend CNY/USD Below Its Long-Term Trend Chart 8US Money Supply Growth Way Outpaces China US Money Supply Growth Way Outpaces China US Money Supply Growth Way Outpaces China The economic fundamentals that have supported the dollar over the past two years are evaporating. The large overhang of China’s local currency money supply may exert structural downward pressure on the RMB exchange rate.5 However, money supply in the US has grown exponentially since the onset of the pandemic and has outpaced that of China (Chart 8). Interest rate differentials between the US and China will likely widen as well. Last week’s FOMC meeting made it clear that the Fed does not intend to raise rates through 2022. In contrast, the PBoC has a track record of normalizing monetary conditions about nine months after a trough in China’s nominal GDP growth (Chart 9). Chart 9The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern The 'Old Faithful' PBoC Policy Normalization Pattern There is mounting evidence that the dollar is entering a new down cycle. Aside from the Fed’s dovish stance, there is mounting evidence that the dollar is entering a new down cycle. Typically, the dollar tends to run in long cycles, of about 10-years, with bear markets defined by rising twin deficits in the US. The reason is that as the Treasury issues more and more debt to finance spending, investors usually require a cheaper exchange rate to keep funding these deficits (Chart 10). Chart 10The Dollar And Cycles The Dollar And Cycles The Dollar And Cycles Chart 11USD A Counter-Cyclical Currency USD A Counter-Cyclical Currency USD A Counter-Cyclical Currency As such, in the next 12 months, barring a second wave of the pandemic that triggers severe lockdown measures, the dollar as a countercyclical currency will be pushed lower as global growth rebounds. This should help strengthen the RMB, given the USD/CNY rate tends to move with the dollar over cyclical periods (Chart 11).   Jing Sima China Strategist jings@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1We assign a 40% probability that the US will revert to tariffs on China within the year. Please see China Investment Strategy Special Report "Watch Out For A Second Wave (Of US-China Frictions)," dated June 10, 2020, available at cis.bcaresearch.com 2As of June 15, 2020, USDCNY exchange rate is at 7.09. 3Please see Foreign Exchange Strategy Weekly Report "USD/CNY And Market Turbulence," dated August 9, 2019, available at fes.bcaresearch.com 4Please see Foreign Exchange Strategy Special Report "A Fresh Look At Purchasing Power Parity," dated August 23, 2019, available at fes.bcaresearch.com 5At around $3 trillion, China’s central bank foreign exchange reserves are equivalent to only 14% of all yuan deposits, and 11% of broad money supply Cyclical Investment Stance Equity Sector Recommendations