United States

Underweight Our recent downgrade in the S&P hypermarkets index to underweight also pushed the overall S&P consumer staples sector to a below benchmark allocation. According to our mid-April research on what sectors investors should avoid during recessionary recoveries, consumer staples stocks trail the SPX on average by 660bps one year following the SPX trough. The current macro backdrop corroborates this analysis and underscores that the path of least resistance is lower for relative staples share prices. Not only is the ISM manufacturing survey on fire, but also consumer confidence is making an effort to trough (ISM manufacturing and consumer confidence shown inverted). Bottom Line: Downgrade the S&P consumer staples index to underweight. For more details, please refer to the most recent Weekly Report. ​​​​​​​

Highlights Historically, soft-budget constraints have typically been followed by periods of poor equity market performance. Soft-budget constraints could produce two distinct economic scenarios: malinvestment or inflation. Both are negative for equity investors. Odds are that the US will continue to pursue easy money policies, sowing the seeds of US equity underperformance in the years ahead. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints, which will weigh on their growth in the near term. However, forced restructuring could boost efficiency and productivity leading to their equity and currency outperformance in the coming years. Unlike other developing economies, China is not currently facing hard-budget constraints. However, the structural overhang from the past 10 years of soft-budget constraints is lingering on and in some cases is increasing. The Thesis The consensus in the investment industry is that cheap money and ample stimulus are good for share prices. We do not disagree with this thesis when it is applied to the near and medium-term equity strategy. However, excessive stimulus and easy money policies — we refer to these as soft-budget constraints — bode ill for share prices in the long run. The investment relevance of this thesis is as follows. Since March, the US has implemented the largest fiscal and central bank stimulus in the world and will likely continue doing so in the coming years (Chart I-1). Such soft-budget constraints will likely support the US economy for now. Nevertheless, they will also sow seeds of future US equity underperformance and currency depreciation. Conversely, many emerging economies (excluding China) have failed to provide sufficient fiscal and credit support to their economies (Chart I-2). The resulting hard-budget constraints will foreshadow their economic underperformance vis-à-vis the US in the coming months. Chart I-1Soft-Budget Policies Will Likely Become Structural In The US Chart I-2EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints   That said, hard-budget constraints will force companies in these EM economies into deleveraging, restructuring and improving efficiency. Ultimately, such hard-budget constraints will benefit EM shareholders in the long run. This thesis has been a key rationale behind our decision to close the short EM / long S&P 500 strategy on July 30, and to turn negative on the US dollar on July 9. In the months ahead, we will be looking for an opportunity to upgrade EM equities to overweight versus the S&P500. BOX 1 Gauging Budget Constraints In our opinion, the best way to gauge budget constraints for the real economy is by monitoring changes in the money supply. This is due to the following reasons: First, net changes in the money supply account for all net loan origination. Second, the money supply also reflects the monetization of public and private debt by the central bank and commercial banks. When a central bank and commercial banks acquire a security from or lend to a non-bank entity, they create new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not change the stock of money supply. We have deliberated on these topics at length in past reports. Securities transactions among non-banks do not create new or destroy existing deposits, i.e., they have no impact on the money supply. Rather, these constitute an exchange of securities and existing deposits between sellers and buyers. Provided these types of transactions do not expand the money supply, they do not, according to our framework, alter budget constraints. Finally, the broad money supply, not central bank assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Commercial banks’ excess reserves at the central bank – a large item on the central bank balance sheet - do not constitute a part of the broad money supply. Empirical Evidence The following are examples of soft-budget constraints that were followed by periods of weakening productivity growth, diminishing return on capital and poor equity market performance: 1. China’s soft budget constraints in 2009-10 Due to the post-Lehman crisis stimulus, the change in broad money exploded above 40% of GDP (Chart I-3, top panel). The economy boomed from early 2009 until early 2011 as cheap and abundant money super-charged investment and consumption. Chart I-3China: Easy Money Presaged Falling Return On Assets And Equity Underperformance However, Chinese share prices — the MSCI China Investable equity index excluding technology, media and telecom (TMT)  — peaked in H1 2011 in absolute terms (Chart I-3, second panel). Relative to the global equity index excluding TMT, the Chinese investable stocks index began underperforming in late 2010 (Chart I-3, third panel). The basis for this equity underperformance was falling return on assets for non-financial companies due to capital misallocation, breeding inefficiencies and diminishing productivity gains (Chart I-3, bottom two panels). In China, the excessive stimulus of 2009 and 2010 and ensuing recurring rounds of soft-budget constraints put a floor under the economy but have destroyed shareholder value. 2. Money overflow in EM ex-China in 2009-10. China’s boom in 2009-10 produced a bonanza for other emerging economies. Not only Chinese imports from developing economies boosted the latter’s balance of payments and income but also international investors rushed into EM equity and fixed income. EM companies and banks took advantage of easy financing and their international borrowing skyrocketed. Finally, EM policy makers stimulated and domestic bank credit boomed. This period of soft-budget constraints led to complacency, lower productivity, falling return on capital and/or inflation in the following years (Chart I-4). Their financial markets performance in the 10 years that followed the soft-budget constraints in 2009-10 has been dismal. The share price index of EM ex-China, Korea and Taiwan as well as the total return on their currencies (including the carry) versus the US dollar have been in a bear market (Chart I-4, bottom two panels). 3. The credit and equity bubbles in Japan, Korea and Taiwan of the late 1980s Money and credit bubbles proliferated in Japan, Korea and Taiwan in the late 1980s (Chart I-5, Chart I-6 and Chart I-7).  Chart I-4EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market Chart I-5Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-6Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-7Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth   Their productivity growth rolled over in the late 1980s amid easy money policies. Share prices deflated in Japan, Korea and Taiwan in the 1990s (please refer to the middle and bottom panels of Charts I-5, I-6 and I-7). Chart I-8ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise 4. The boom-bust cycle in emerging Asia ex-China in the 1990s Soft-budget constraints prevailed in many emerging Asian economies in the first half of the 1990s. Foreign money inflows and domestic bank credit produced an economic boom. The consequences of such soft-budget constraints were debt-financed malinvestment, falling return on assets and massive current account deficits (Chart I-8). All of these culminated in epic currency and banking crises. 5. The credit bubbles in the US and Europe leading to the 2008 crash Lax credit standards propelled credit and property booms in the US and Southern Europe in the period of 2002-2007. Broad money ballooned in the euro area and swelled in the US (please refer to Chart I-1 on page 2). These property bubbles unraveled in 2007-08. These are well known, and we will not delve into the details. Soft-Budget Constraints Lead To Malinvestment Or Inflation Soft-budget constraints could produce two distinctive economic scenarios – malinvestment or inflation. Both are negative for equity investors. The malinvestment scenario occurs when easy money propels undisciplined capital spending. Easy and abundant money boosts medium-term growth and, thereby, creates the illusion of an economic miracle. The latter renders companies, creditors, investors and government officials complacent. Creditors lend a lot and do so based on optimistic assumptions while companies expand hastily and invest carelessly. The result is capital misallocation, i.e., companies pour money into projects that do not ultimately produce sufficient cash flow. Equity investors project high growth expectations into the future and bid up share prices. Government officials preside over an unsustainable growth trajectory overlooking lurking systemic risks and deteriorating economic fundamentals. Easy money and unlimited financing typically bode ill for efficiency and productivity— this is simply due to human nature. Companies neglect efficiency considerations and, as a result, productivity stagnates. Consequently, cost overruns and unprofitable investments suffocate corporate profits. Declining corporate earnings at a time of expanded capital base culminate in a collapse of return on capital. This is the crucial reason why share prices drop. As profits and return on capital decline, companies retrench by cutting costs and halting investment spending. Defaults mushroom, leading creditors to cut new financing. The inflation scenario transpires when easy money boosts consumption more than investment. Easy money and unlimited financing lift household income and consumption. This can arise from a large fiscal stimulus or private sector's borrowing and spending. On the one hand, robust household income growth inevitably leads to higher wage growth expectations. On the other hand, limited investment brings about productivity stagnation. Mounting wages and languishing productivity growth lead to rising unit labor costs and, ultimately, result in a corporate profit margin squeeze. Faced with corporate profit margin shrinkage, companies either raise prices, i.e., pass through higher costs, or retrench by shedding labor and shrinking capital spending even further. The latter produces a widespread economic downturn, and stifles business profits and share prices. A symptom of higher inflation is a wider current account deficit. With an economy’s productive capacity lagging behind demand, the gap between the two can be filled in by imports. In addition, escalating domestic costs make a country less competitive, which inhibits exports and bloats imports. When a central bank is unwilling to tighten monetary policy meaningfully amid high and rising inflation and/or a widening current account deficit, it falls behind the inflation curve. This constitutes a very bearish backdrop for the exchange rate. Currency depreciation erodes the country’s equity returns in common currency terms versus other bourses. Can an economy with soft-budget constraints, i.e., booming money growth, avoid both malinvestment and inflation? Yes, it can if it is able to boost productivity growth so that it avoids systemic capital misallocation (i.e., investments produce reasonable returns to pay off to creditors and shareholders) and escapes higher inflation by expanding output faster to meet growing demand. However, achieving higher productivity growth amid soft-budget constraints is easier said than done. Bottom Line: The scenario of malinvestment has been playing out in China since 2009. Capital misallocation also occurred in the US and parts of Europe during the 2002-2007 credit boom, and took place in Japan, Korea and Taiwan in the late 1980s. Malinvestment, with some elements of inflation, occurred in emerging Asian countries prior the 1997-98 crises as well as in many EM economies like India, Indonesia and Brazil in 2009-2012. Investment Implications It is fair to say that the unprecedented economic downturn in the US warranted an exceptionally large stimulus. The question for the next several months and years is whether US authorities will: overstay easy policies and make soft-budget constraints a permanent feature of the US economy, or tighten policy earlier than warranted, or navigate policy perfectly so that the economy is neither too hot nor too cold. Our sense is that US authorities will overstay their easy money policies. If the US continues to pursue macro policies in the form of soft-budget constraints, will the nation experience malinvestment or inflation? Our sense is that the US will likely experience asset bubbles and inflation. As the Federal Reserve stays behind the inflation curve in the coming years, the US dollar will be in a multi-year downtrend. Hence, the strategy should be selling the greenback into rebounds. We switched our short positions in select EM currencies— such as BRL, CLP, ZAR, TRY, KRW, IDR and PHP —away from the US dollar to an equal-weighted basket of the euro, CHF and JPY on July 9. For now, EM currencies will lag DM currencies. US equity outperformance versus the rest of the world is in the late innings (Chart I-9). The pillars of US equity underperformance in common currency terms will be excessive US equity valuations, a potential new era of US return on capital underperforming the rest of the world and greenback depreciation. Chart I-9US Equity Outperformance Is In Very Late Stages The top panel of Chart I-10 illustrates that the difference between US investors owning international stocks and non-US investors holdings of US equities is at a record low. This reveals that both US and foreign investors currently "over-own" US stocks versus non-US equities. Perfect timing of a structural trend reversal is impossible, but we believe US equity outperformance will discontinue before year-end. That was the rationale behind terminating our short EM / long S&P 500 strategy and upgrading EM equity allocation from underweight to neutral. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints which will weigh on their economic performance in the near term. This is why we are not rushing to upgrade EM stocks and currencies to overweight. However, the lack of cheap money will force these EM countries and their companies to do the right things: deleverage households and companies, clean up and recapitalize their banking systems and undertake corporate restructuring. Ultimately, hard-budget constraints will likely sow the seeds of high productivity and, with it, equity and currency outperformance in the years to come. China is a tricky case. On a positive note, it has not stimulated as much during the pandemic as it did in 2009. Besides, policymakers are now aware of the ills that come with soft-budget constraints and have been working hard to address these. Critically, the Chinese population, businesses and the authorities are all united in the nation’s confrontation with the US. Complacency in this context is not a major risk and the focus on efficiency and productivity will be razor sharp. On the negative side, the credit, money and property bubbles that had not been dealt with before the pandemic are now increasing with the stimulus. Continued malinvestment and falling return on capital in China’s old economy sectors is signified by the very poor performance of China’s cyclical “old economy” stocks (Chart I-11, top panel). In turn, bank share prices are making new cyclical lows underscoring their worsening structural outlook (Chart I-11, bottom panel). Chart I-10Global Equity Investors Over-Own US Stocks Versus International Ones Chart I-11Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises   Weighing the pros and cons, we infer that the cyclical recovery in China has further to run. This will support China’s growth and equity outperformance for now. That is why we continue to recommend overweighting China within an EM equity portfolio. However, as the credit and fiscal impulses fade starting in H1 next year, structural malaises will resurface posing risks to China’s equity outperformance.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear clients, China Investment Strategy will take a summer break next week. We will resume our publication on September 9th. Best regards, Jing Sima, China Strategist   Highlights The threat of US sanctions has sparked fears of disconnecting Chinese financial institutions from US dollar access, driving urgency to accelerate the RMB internationalization process. China’s RMB internationalization process suffered from a sizable setback in 2016, but the trend has reversed in 2018. Since then China has shifted the strategy to broaden and enhance the RMB’s market demand and functions, as well as to establish systems to facilitate the strategy. In the foreseeable future, the RMB’s role in the global economy is far from challenging the US dollar as the world's dominant reserve currency; China's near-term goal to promote the use of the RMB beyond its borders is to minimize disruptions to China’s trade and investment activities threatened by US financial sanctions. Feature Since 2018 and in the wake of intensifying confrontations between the US and China, the Chinese government has shifted its strategy in promoting the internationalization of the RMB. Authorities have moved from a symbolic international recognition of the RMB to a more pragmatic approach of creating real market demand for the currency. Chart 1China Has Been Shedding USD Assets It is not our baseline view that the US will take extreme measures and entirely cut off Chinese banks’ access to the US Clearing House Interbank Payments System (CHIPS) and the Society for Worldwide Interbank Financial Telecommunication (SWIFT). However, Beijing’s decoupling from the US dollar (USD) has been in process, diversifying its forex reserves away from the US dollar (USD) and increasing the use of the RMB in cross-border trade and investment (Chart 1). In the foreseeable future, it is neither possible nor is Chinese policymakers’ intention for the RMB to challenge the USD as the world's dominant reserve currency. Rather, we think that under the threat of US sanctions, the near-term goal is to minimize disruptions to China’s trade and investment activities.  At the same time, the approach will make China “too big, too connected to fail” in the medium-to-long run and, therefore, minimize the potential for future threats of financial sanctions. China’s new approach to internationalize the RMB involves enhancing the currency’s three functions in the global market, and establishing and strengthening domestic systems to facilitate the enhancements: The RMB as an international settlement currency; The RMB as a commodity pricing currency; and The RMB as an international reserve currency. Most of these strategies still have a long way to go before having significant global market implications. However, these developments bear structural importance and investors should closely monitor them. RMB - An International Settlement Currency Chart 2Cross-Border RMB Settlement Is Picking Up The RMB’s role in cross-border trade settlement suffered a major setback in 2016 when investor confidence plummeted following a rapid devaluation in China’s currency and equities. The trend has reversed since 2018, partially due to the vigorous promotion of China’s domestic cross-border interbank settlement system (CIPS) (Chart 2). China established CIPS in 2015 after the US proposed to disconnect Russia from the SWIFT payment system.1 As of July 2020, the CIPS system had a total of 33 direct participants and 951 indirect participants, a 35% increase from 2018 with more than half of the participants outside China.2 According to the recently released PBoC RMB internationalization report, the CIPS system processed a total of 34 trillion yuan worth of cross-border RMB transactions in 2019, a 28% improvement from 2018 (Chart 3). Chart 3CIPS Has Been Steadily Expanding Nevertheless, the RMB’s share of international payments remains far behind the USD, euro and yen, and the RMB's role in cross-border settlement is well below its 2016 peak (Chart 4A and 4B). The dollar's dominant status is not only supported by the US’ strong and open economy, but also by its deep, liquid and highly efficient financial markets, which are impossible for any currencies or payment systems to replicate in the near future. However, establishing domestic financial payment and information exchange systems will likely be a main countermeasure countries will rush to take, if the US launches sanctions to cut off large economies like Russia and China from the USD and/or global financial system.  Chart 4AThe RMB’s Share Of International Payments Has Been Disproportional Compared To Its Share In Global Trade… Chart 4B...And Well Below Its 2016 Peak Chart 5Russia Has Largely Replaced USD Treasury Holdings With Gold Russia is by far the largest and most globally integrated country that came close to being cut off from SWIFT, and Beijing has clearly learned from Russia’s experience and countermeasure strategies. The proposal to disconnect Russia from SWIFT following the 2014 Crimea crisis never materialized, but in light of the threats and US financial sanctions, Russia established the SPFS, a domestic financial information exchange system to facilitate bank payments. The SPFS is far from the complete emancipation of SWIFT and payments through the SPFS are mostly intra-Russian settlements. However, this active counter-sanction measure, coupled with the Russian central bank’s aggressive reduction of USD-denominated assets in its forex reserves, seems to have achieved positive results (Chart 5). Three years after the establishment of SPFS, the US and Europe no longer target Russian bank payment functions in their further financial sanctions against Russia.3 In response to a US threat to impose economic sanctions against companies and banks dealing with Iran, Europe created a special financial settlement platform called Instrument in Support of Trade Exchanges (INSTEX) in 2019. Although none of the alternative systems can challenge the role of the US CHIPS or SWIFT systems, the trend of establishing and accelerating alternatives will incrementally diminish the effectiveness of such harsh financial actions by the US. RMB - An International Commodity Pricing Currency Table 1China Dominates Global Demand For Many Commodities We believe that the most important breakthrough in the RMB internationalization process in the past five years has been the strategic shift to promote the RMB’s pricing function. China is the largest trading partner of a growing number of countries with tightly linked supply chains. This generates a natural demand for RMB settlement in bilateral trade. More importantly, China’s dominance in global demand for bulk commodities gives the country an advantage in pricing power (Table 1). In March 2018, China established a RMB-denominated crude oil futures market in Shanghai, which has grown into the third-largest oil exchange market after WTI and Brent. Its cumulative turnover in two years reached nearly 30 trillion yuan with overseas customers in 19 countries and regions.4 Given the success of the Shanghai crude oil futures market, the Chinese government has been vigorously promoting the expansion of the RMB pricing function from crude oil to natural gas, iron ore, soybeans, corn and other bulk commodities. Going forward, we expect the RMB internationalization process to continue to develop through pricing and trading bulk commodities in Chinese currency.  This will lead to a higher correlation between the RMB and the currencies of some of China's Asian neighbors and commodity trade partners, and thus expand and strengthen the "RMB currency bloc" (Chart 6A and 6B). Chart 6AThe RMB Currency Bloc May Expand From Manufacturing Ecosystem... Chart 6B...To Commodity Supply Chain RMB - An International Reserve Currency The role of the RMB among official reserve managers, although still dismal compared to the USD and Euro, has accelerated since 2018. Its global share has doubled from Q4 2016 when the IMF began to include holdings of RMB in its currency composition of official foreign exchange reserves (COFER) (Chart 7). Shares of the USD- and Euro-denominated reserves have remained unchanged or declined during the same period. Among private investors, foreign investment in RMB-denominated assets has been the main source of China’s financial account surplus (Chart 8). China has hastened the opening of its onshore financial market to foreign institutional investors. In the past two years, major global stock and bond indexers –including MSCI, the S&P Dow Jones Indices, the FTSE Russell, and the Bloomberg Barclays Global Aggregate Index – have added A-shares and onshore bonds to their flagship benchmarks. This means that foreign institutional investors have significantly boosted their allocation of RMB-denominated stocks and bonds (Chart 8, bottom panel). Financial assets, such as domestic RMB stocks, bonds, and loans and deposits held by foreign entities, climbed by 26.7% in 2019 over 2018. At the same time, China's domestic financial markets have gradually liberalized and even removed investment quotas for overseas institutional investors. Foreign investors currently account for 5.5% and 2.6% of the market value in Chinese equities and bonds, up from 3% and 2% in 2018, respectively. Chart 7The RMB Share In Global Reserves Remains Dismal, But Has Nearly Doubled Since 2016 Chart 8China Has Been Rapidly Expanding The Scope Of Foreign Participants In Its Onshore Financial Markets Bottom Line: The internationalization of the RMB will likely continue to accelerate in the face of decoupling from the US. It is a long process, but China will take advantage of its dominance in global demand to foster the RMB's role in both pricing and settlement in cross-border commodity trade. At the same time, China is rapidly expanding the scope of foreign participants in the country's onshore financial markets, by allowing more foreign banks and financial institutions to enter the market, and broadening the channels for the RMB’s international circulation.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1SWIFT is a system that provides information on international payments and calculations. The system unites more than 11,000 banking and financial institutions in 210 countries and the bank card payment function supported by the SWIFT system reflects a country's financial security. 2China Cross-Border Interbank Payment System release, July 31st, 2020. 3Xu Wenhong, The SWIFT System: A Focus on the U.S.–Russia Financial Confrontation, Russian International Affairs Council, February 3, 2020. 4Based on data from Shanghai International Energy Exchange. Cyclical Investment Stance Equity Sector Recommendations

Underweight We have been adding cyclical exposure to the portfolio and lightening up on defensives and as a continuation of this shift we recently downgraded the S&P hypermarkets group to underweight. The economy is reopening and thus it no longer pays to seek refuge in safe haven hypermarket equities. In fact, most of the macro indicators we track suggest the recession is over that will sustain severe downward pressure on relative share prices. The chart on the right shows that the ISM manufacturing new orders subcomponent has slingshot from below 30 to north of 60, junk spreads are probing all-time lows, consumer confidence has troughed and small and medium enterprises hiring intentions are on the mend. Bottom Line: Trim the S&P hypermarkets index to underweight. The ticker symbols for the stocks in this index are: BLBG S5HYPC – WMT, COST. For more details, please refer to this Monday’s Weekly Report. ​​​​​​​