United States

Highlights The dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds. The reason is that the economic landscape remains fraught with uncertainty, both politically and economically. We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and GBP along with some safe havens. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for dollar downside. The EUR/USD could touch 1.16, while still staying in the confines of a structural bear market. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Feature Chart I-1The Dollar Tries To Break Down The DXY index is punching below key support levels in an attempt to reverse the cyclical bull market in place since 2011. Our technical roadmap has been the upward-sloping channel, in place since 2018 (Chart I-1). At 96.77, the DXY index is already several ticks below the lower bound of this channel. As the breakdown becomes more broad based, especially vis-à-vis the euro, this will cement the transition from easing financial conditions to improving global growth. Cyclical currencies such as the Australian dollar and the Norwegian krone have already bounced powerfully from their March lows and have now entered the technical definition of a bull market (Chart I-2). For example, from a low of 55 cents, the Aussie is now trading at 69 cents, up 25%. As long-term dollar bears, our portfolio has benefited tremendously from this shift in market sentiment.1  Chart I-2A Report Card On Currency Performance The key question for new investors is whether the move in the dollar represents a false breakdown or the beginning of a cyclical bear market. To answer this, we are reviewing key charts and indicators to explain dollar weakness and help gauge whether it pays to enter new short positions. Explaining Dollar Weakness US dollar weakness has been driven by three interrelated factors: Non-US economies that were initially hit by COVID-19 are reopening faster. As a result, economic momentum is higher outside the US. The rise in economic momentum is supporting money velocity outside the US. In other words, animal spirits are being rekindled at a faster pace abroad. In the classical equation MV=PQ,2 a rise in both M and V can be explosive for nominal output. Higher money velocity outside the US has started to attract capital inflows. This is beginning to show up in the outperformance of non-US markets. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace.  Chart I-3 shows that dollar strength throughout most of March can be partly explained by the relative resilience of the US economy, in part driven by a late start to state-wide shutdowns. This was exacerbated by a dollar liquidity shortage, as demand for US dollars abroad surged. With economies outside the US now reopening, PMIs abroad have recovered at a faster pace. As Chart I-2 illustrates, developed market currencies have fared in pecking order of the easing in lockdown measures, with the AUD outperforming the CAD, and the SEK outperforming the EUR. Prior to the onset of COVID-19, there was a pretty tight correlation between global services relative to manufacturing activity and the dollar (Chart I-4). As a relatively closed economy, the US tended to benefit when services output had the upper hand. This time around, the service sector has been hit much harder due to social distancing measures in place, but it is also likely to have a more drawn-out recovery. For example, visits to theme parks or restaurants are unlikely to retrace back to their pre-crisis peaks anytime soon. However, construction activity, especially geared towards infrastructure or residential housing, may bounce back sooner. Chart I-3A Strong Recovery Outside The US Chart I-4USD And Manufacturing Vs Services The key message is that global manufacturing activity so far is holding up better than services, and activity is picking up faster abroad. This has historically been good news for procyclical currencies. Money Velocity And The Dollar There is increasing evidence that money velocity is being supported outside the US. For global manufacturing activity to recover, it requires a rise in animal spirits to begin to capitalize on very generous financing conditions. In this respect, there is increasing evidence that money velocity is being supported outside the US. In the euro area, the velocity of money in Germany has stopped falling relative to the US. This is a marked change from anything we have seen since the European debt crisis. More importantly, the ebb and flow of ‘V’ in Germany relative to the US has mirrored the relative path of interest rates (Chart I-5). Global industrial activity remains quite subdued, but it appears that sentiment among German investors is very upbeat for the post-COVID recovery. This has usually been a good barometer for the improvement in PMIs (Chart I-6). Granted, the improvement in relative V has been driven mostly by the collapse in US money velocity. But what matters for currencies are relative trends. Once economic activity enters a full-fledged recovery, we expect US output to be hampered by the rise in the dollar over the past 18 months, while cyclical economies will be buffeted by much-cheapened currencies. This raises the prospect of much more pronounced economic vigor outside the US. Chart I-5Money Velocity Support In Europe Chart I-6Euro Area Sentiment Is Improving The ratio of the velocity of money between the US and China has tended to track the gold/silver ratio (GSR) with a tight fit (Chart I-7). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the US. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses than gold. Therefore, the recent collapse in the GSR is prescient.   Soft data confirms this trend. Both the Caixin and NBS manufacturing PMI are outperforming that in the US, and are likely to keep doing so in the coming months (Chart I-8). Chart I-7Money Velocity Support In China? Chart I-8Wide Gap Between Chinese And US Output It is important to note that while there has been some disconnect between the performance of the economy and stock prices, no such dichotomy exists in currency markets. The ratio of cyclical currencies relative to defensive ones tends to track the global PMI directionally. While this ratio is below its 2008 lows, the global PMI has bottomed at higher levels (Chart I-9). The difference can probably be explained by the fact that either domestic investors (especially retail) have been the dominant buyers of equities, and/or institutional investors have been hedging currency risk. It is true that the bounce in AUD/CHF (or other procyclical pairs) from the lows has brought it closer to technically stretched levels, and some measure of indigestion is overdue. That said, this mainly reflects mean reversion from deeply oversold levels (Chart I-10). If manufacturing activity can keep improving, and the velocity of money outside the US can pick up, this will revive capital flows into these markets, which will lead to more pronounced breakouts. Given the huge uncertainty surrounding these forecasts, we believe the risk to the greenback is currently balanced. Chart I-9Equity And Currency Markets Have Diverged Chart I-10Still Oversold Capital Flows As An Indicator The nascent upturn in a few growth indicators is also coinciding with a positive signal from equity markets. Global cyclical stocks have started to outperform defensives in recent weeks, as flows into more cyclical ETF markets are accelerating (Chart I-11). Chart I-11Inflows Into Cyclical ETFs Chart I-12Inflows Into US Assets Are Picking Up The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Indeed, the latest data show that as recent as March, net foreign inflows into US equity markets were quite strong (Chart I-12). This might explain why the S&P 500 continued to outperform during the March drawdown. In a nutshell, the outperformance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to the euro area, commodity-producing countries, and other emerging and developed market currencies (Charts I-13A and I-13B). The catalyst will have to be rising relative returns on capital outside the US, but the starting point is also extremely attractive valuations. Chart I-13ANascent Bounce In Cyclicals Versus Defensives Chart I-13BNascent Bounce In Cyclicals Versus Defensives We recently penned a report titled “Cycles And The US Dollar,” which showed empirically that US valuations have more than fully capitalized future earning streams, especially vis-à-vis their G10 peers. That said, before a cyclical bear market can fully unfold, we are watching two key indicators for dollar downside: As the Fed continues to dilute existing bond shareholders, the ratio of the US bond ETF (TLT) to gold (GLD) will be an important proxy for investor sentiment. One of the functions of money is as a store of value, and gold remains a viable threat to the dollar (and Treasurys) in this regard. A falling ratio will suggest private investors are dumping their bond holdings in exchange for harder assets such as precious metals. Recent inflows into the GLD ETF may be signaling such a shift (Chart I-14), but it will take a clean break in this ratio below 0.95 to solidify the trend. As geopolitical tensions between US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, USD/CNY is holding close to cyclical highs, but a break above will put Asian currencies at risk. This will have negative implications for developed-market commodity currencies (Chart I-15). Chart I-14Gold And USD Inflows Diverge Chart I-15Tied To The Hip EUR, GBP And Housekeeping We continue to recommend a barbell strategy. Hold a basket of the cheapest currencies such as the NOK, SEK, and the GBP along with some safe havens. Being short the gold/silver ratio is also a good way to play an eventual economic recovery, with the benefit of a tremendous valuation cushion. The market certainly applauded the European Central Bank’s addition of €600 billion in bond purchases, given the fall in peripheral bond spreads. The euro also bounced on the back of two factors: Chart I-16QE And EUR/USD Even with additional stimulus, the balance sheet impulse of the Fed is still larger than that of the ECB (Chart I-16). Historically, this has favored long EUR/USD positions. The compression in peripheral spreads should boost European growth as it lowers the cost of capital for countries such as Spain and Italy. This improves debt dynamics and encourages the productive deployment of capital. Technically, the EUR/USD can rally towards 1.16 while remaining within the confines of a structural bear market (Chart I-17). Beyond this point, it will be imperative for European growth dynamics to take over the baton to support a much higher exchange rate. As we mentioned earlier, the velocity of money in Germany has stopped falling relative to the US, but relative improvement is not yet enough to warrant structural positions in EUR/USD. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Our FX model is more aggressive, and is recommending shorting the DXY for the month of June. Since the 1980s, this three-factor model has outperformed the DXY index by a significant margin (Chart I-18). Chart I-17EUR/USD Could Touch 1.16 Chart I-18The Model Is Short DXY In June Finally, our limit-sell on EUR/GBP was triggered at 0.90 last week. While valuation favors a short position, the ramp-up in Brexit tensions is a key risk to this trade. As such, we are placing tight stops at 0.905.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been negative: Headline PCE fell from 1.3% to 0.5% year-on-year in April. Core PCE also declined from 1.7% to 1%. Personal income surged by 10.5% month-on-month in April, while personal spending decreased by 13.6%, implying a higher savings rate. Total vehicle sales increased from 8.6 million to 11 million in May. Factory orders fell by 13% month-on-month in April. The trade deficit widened from $42.3 billion to $49.4 billion in April. Initial jobless claims increased by 1877K for the week ended May 29th. The DXY index fell by 1.1% this week, reflecting cautiously positive sentiment as many countries started to ease lockdown measures.   Report Links: Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Dollar Funding Crisis - March 19, 2020   The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Headline inflation fell from 0.3% to 0.1% year-on-year in May, while core inflation was unchanged at 0.9%. The unemployment rate increased from 7.1% to 7.3% in April. The Markit manufacturing PMI slightly fell from 39.5 to 39.4 in May, while the services PMI increased from 28.7 to 30.5. Retail sales plunged by 19.6% year-on-year in April, following an 8.8% decline the previous month. EUR/USD appreciated by 1.4% this week. On Thursday, the ECB kept key interest rates unchanged, while announcing a further 600 billion euros increase of its PEPP facility, taking the total to 1.35 trillion euros. There was also an extension of the program till June 2021.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019   The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders plunged by 14.3% year-on-year in April. Housing starts fell by 12.9% year-on-year in April. Capital spending increased by 4.3% quarter-on-quarter in Q1. The monetary base surged by 3.9% year-on-year in May. The manufacturing PMI was unchanged at 38.4 in May, while the services PMI increased from 21.5 to 26.5. The Japanese yen fell by 1.3% against the US dollar this week. Japan lifted its nationwide state of emergency last week, however, the economy is still in deep recession as COVID-19 continues to disrupt global supply chains.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The Markit manufacturing PMI slightly increased from 40.6 to 40.7 in May. The services PMI also ticked up from 27.8 to 29. Nationwide housing prices fell by 1.7% month-on-month in May. Money supply (M4) surged by 9.5% year-on-year in April. Mortgage approvals increased by 15.8K in April, down from 56K the previous month. GBP/USD increased by 1.7% this week. The Bank of England urged banks to step up no-deal Brexit plans this week, implying that there might have been a shift in the BoE’s assumptions about the outcome of ongoing talks between the UK and the European Union. That being said, we remain bullish on the pound from a valuation perspective, but are tightening our stop loss this week.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019   Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The manufacturing index increased from 35.8 to 41.6 in May. The current account surplus increased from A$1 billion to A$8.4 billion in Q1. However, more recent trade data was less encouraging. Imports plunged by 9.8% month on month in April while exports slumped by 11.3%. The trade surplus narrowed from A$10.6 billion to A$8.8 billion. GDP grew by 1.4% year-on-year in Q1. On a quarterly basis, it fell by 0.3% compared with the last quarter in 2019.  Building permits increased by 5.7% year-on-year in April. AUD/USD appreciated remarkably by 4.5% this week. On Tuesday, the RBA kept its interest rate unchanged at 0.25%. Moreover, the RBA sounds cautiously positive in its rate statement, saying that “it is possible that the depth of the downturn will be less than earlier expected.”   Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Terms of trade fell by 0.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. It is the first fall since Q4 2018. Building permits fell by 6.5% month-on-month in April, following a 21.7% monthly decrease in March. NZD/USD increased by 4% this week. The fall in terms of trade was led by the decline in meat prices, including lamb and beef, from record levels at the end of 2019. Forestry product prices also fell by 3.4% quarterly in Q1. On a positive note, New Zealand is prepared to ease lockdown measures as there has been no new cases reported for nearly two weeks.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019   Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: GDP plunged by 8.2% quarter-on-quarter in Q1. The Markit manufacturing PMI increased from 33 to 40.6 in May. Labor productivity increased by 3.4% quarterly in Q1. Imports fell from C$48 billion to C$36 billion in April. Exports also declined from C$46 billion to C$33 billion. The trade deficit widened from C$1.5 billion to C$3.3 billion.  The Canadian dollar rose by 2.2% this week, alongside oil prices. On Wednesday, the BoC kept interest rates unchanged at 0.25%. It also decided to scale back the frequency of some market operations as financing conditions have improved.   Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses   Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell from 59.7 to 53.2 in May. Real retail sales plunged by 20% year-on-year in April, following a 5.8% decrease the previous month. The manufacturing PMI increased from 40.7 to 42.1 in May. GDP declined by 1.3% year-on-year in Q1. On a quarter-on-quarter basis, GDP fell by 2.6% compared with Q4 2019.  Headline consumer prices kept falling by 1.3% year-on-year in May. The Swiss franc rose by 0.5% against the US dollar this week. The 2.6% quarterly decline in Switzerland’s GDP has been the most severe since 1980, mostly led by hotels and restaurants which suffered a 23.4% fall. In addition, the consistent decline in consumer prices might lead the SNB to further step up FX intervention.   Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There has been scant data from Norway this week: The current account surplus increased from NOK 25 billion to NOK 66 billion in Q1. The Norwegian krone appreciated by 3.5% against the US dollar this week. Statistics Norway’s recent balance of payments report shows that the balance of goods and services surged to NOK 27 billion in Q1. Balance of income and current transfers also increased from NOK 1.9 billion to NOK 38.9 billion. Our Nordic basket against the euro and the US dollar is now 10% in the money.   Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020   Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: GDP increased by 0.4% year-on-year in Q1, down from 0.5% the previous quarter. The trade surplus increased from SEK 5.2 billion to SEK 7.6 billion in April. The manufacturing PMI increased from 36.4 to 39.2 in May. Industrial production plunged by 16.6% year-on-year in April. Manufacturing new orders also declined by 20.7% year-on-year. The Swedish krona increased by 2.5% against the US dollar this week. Sweden’s GDP grew modestly in Q1, which is better than most of its European counterparts, following its decision not to impose a full lockdown to contain the virus.   Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019   Footnotes 1Please see our table of trades below. 2Where M = money supply, V = velocity of money, P = price level and Q = output.   Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

The recently instituted S&P biotech rolling stop got triggered yesterday and we crystalized gains of 5% since the February 2019 inception. This index is now downgraded to neutral, but it does not affect the overall S&P health care positioning that remains modestly overweight. The recent selloff in the bond market along with the catch up phase in earnest of the more cyclically sensitive parts of the equity market explain the rolling stop trigger in the S&P biotech index. None of the upbeat demand drivers have changed since our last update, however we are obeying our stop in order to protect profits from a portfolio management perspective. Bottom Line: Trim the S&P biotech index to neutral for a gain of 5% since inception. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX. ​​​​​​​

Highlights Our base case reflects our view that China’s strong fiscal and monetary stimulus, combined with a weaker US dollar, will provide a favorable backdrop for copper markets in 2H20. Supply factors are for the most part reflected in current copper prices. In 2H20, the speed of the demand recovery will be the determining factor for prices. Global policy uncertainty remains high.  Assessing the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted will keep uncertainty at relatively high levels.  A possible second wave of COVID-19 returning large economies to lockdown status looms large for copper markets, and for commodity markets generally. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines could keep the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin. Tactically, we remain on the sidelines until the fog clears around these known and unknown unknowns.  A $3/lb COMEX refined copper price is likely in 2H20, but the risks to this outlook remain high. Feature Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Copper prices will end the year higher vs. current levels in our base case. But uncertainty remains elevated. Assessing the synchronicity of EM recoveries and the joint effects of global monetary and fiscal stimulus, along with consumers’ willingness to spend once lockdowns are lifted is extremely difficult. Looming over all of these considerations: A possible second wave of COVID-19 returning large economies to lockdown status loom large. Tactically, we remain on the sidelines as the fog clears around some of these known and unknown unknowns. Importantly, our positive view rests on our expectation of a robust recovery in China’s economic activity and, to a lesser extent, in its main export destinations, which were hit later by the pandemic. A weak recovery in China would slow the rate at which the current copper supply surplus subsides. At ~ $2.50/lb, copper prices have recovered significantly since bottoming in March at $2.11/lb on the COMEX. Still, clearing the $3.30/lb double top reached in June 2018 will require either a significant increase in global demand or a sharp contraction in supply, which we do not expect. Copper markets were severely hit by the global pandemic: Prices fell 10% in January, as the case count grew in China – the largest copper-consuming market – followed by another 19% decline as the virus spread globally (Chart of the Week). The intensification of lockdowns globally pushed copper markets to a 60k MT surplus as of March – the latest data reported by the World Bureau of Metal Statistics (WBMS) – from a 20k MT deficit in 2019. Bearish sentiment moved our Tactical Composite Indicator – which captures sentiment, positioning, and momentum dynamics – to oversold territories on in March (Chart 2). Chart of the WeekCopper Prices Were Severely Hit By The Pandemic Chart 2Bearish Sentiment Crushes Copper Prices After reaching a low of $2.11/lb on March 23, COMEX copper prices surged 18% with few interruptions as the Chinese economy reopened, and global monetary and fiscal authorities supplied unprecedented economic support (Chart 3). This prompted a wave of short-covering by money managers, releasing some of the downward pressure on prices (Chart 4). Chart 3Unprecedented Fiscal Response Chart 4Money Managers Neutral For Now Still, hedge funds have not yet entered bullish positions on the metal. And, importantly, inventory levels are not drawing sharply. China’s Economy Bottomed, World ex-China Still Contracting Our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. Since the end of the Global Financial Crisis (GFC), copper prices have mostly shadowed China’s economic cycles (Chart 5). China’s importance for copper markets now dominates that of major DM countries (Chart 5, panel 3). The influence of global supply-demand fundamentals on copper prices has declined. Prices are increasingly policy-driven with supply adjusting to demand as dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in that economy. Thus, our outlook hinges primarily on our assessment of China’s policy-driven copper demand – both from domestic usage perspective, and, to a lesser extent, from copper-intensive exported goods. According to the International Copper Study Group (ICSG), around 17% of Chinese copper demand comes from exports of products containing copper.1 In “normal” times, we rely heavily on our monthly indicators to gauge economic and commodity cycles. However, the speed with which the COVID-19 pandemic evolves – and the associated fiscal and monetary responses to it – makes short-term forecasting of cyclical commodities a perilous task. Chart 5DM Consumption Pales Vs. China High-frequency data suggest Chinese economic growth bottomed in March and is rapidly recovering (Chart 6). Chart 6Chinese Economy Returning To Normal Meanwhile in China’s major export destinations, the number of confirmed COVID-19 cases appear to be flattening, containment measures are gradually easing, and mobility is improving (Chart 7, panel 1 and 2). Globally, the copper- and oil-to-gold ratios have stabilized, and stock prices for nine of the largest copper producers have trended up since March 23 (Chart 7, panel 3 and 4). That said, we believe it is still too early to adopt a high-conviction view about a price recovery trajectory. For one, China recently reintroduced containment measures in certain regions, as clusters of coronavirus cases were detected, highlighting the fragility of the current recovery.2 Chart 7China's Major Export Partners Could Rebound Soon Chart 8Strong Domestic Demand, Weak Export Growth Moreover, the rebound in overall Chinese demand hasn’t fully offset the collapse in its exports. As a result, the reopening of the supply side of the economy outpaced demand growth (Chart 8). Extrapolating this to its copper market: Chinese refined copper production (40% share of world output) is facing robust domestic demand but weak export demand for copper (44% and 9% of world demand), leaving its market with a supply surplus. Nonetheless, absent a severe second wave of COVID-19 cases, the infrastructure-focused stimulus and market-friendly real estate policies in the country will allow internal demand to overtake production in 2H20, despite limited external demand (more on this below). China’s Credit Growth To Drive Copper Demand Higher The key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy.  Markets were unimpressed by the fiscal package announced during China’s National People’s Congress (NPC) last month, which, for the first time in decades, did not contain an annual economic growth target in the Government Work Report (Table 1). Even so, the key message emerging from the NPC is that policymakers are willing to do whatever it takes – including abandoning their deleveraging objectives – to reflate the economy. Broad money and total social financing growth will accelerate relative to last year and notably exceed nominal GDP growth. Our Emerging Markets strategists expect China’s fiscal and credit impulse will reach 15.5% this year (Chart 9).3 Table 1No Economic Growth Target In The Government Work Report Additionally, China pledged to stabilize employment and targeted the creation of 9 million new jobs in urban areas. This is an ambitious target amidst the massive layoffs induced by the COVID-19 pandemic this year. Chart 9Chinese Credit Growth Will Surge Policymakers also reserved policy space to be used – without the approval of the NPC at the Politburo’s mid-year review – in the event the shock from the pandemic proves persistent.4 Past episodes of Chinese stimulus resulted in strong rallies in base metals prices. Given China now represents more than half of global copper consumption (vs. 43% in 2009 following the GFC, and 32% in 2012 following the euro area debt crisis), we expect this new round of stimulus will lead to a sharp increase in copper prices.5 By and large, refined copper prices are highly sensitive to growth in EM imports – particularly China’s – which are closely tied to income growth. The latest CPB World Trade Monitor data for March shows EM ex-China imports have been resilient suggesting the rebound in China’s economic activity might be spilling over to other EMs highly leveraged to China (Chart 10). Still, our main cyclical commodity demand indicators were declining as of April. We expect stimulus-driven EM income and investment growth will show up in our indicators in 2H20 (Chart 10). Chart 10Awaiting A Rebound In Our Cyclical Indicators Stalling Primary And Secondary Supply Growth In addition to the demand implications, lockdowns also resulted in restrictions – and few complete shutdowns – in mining activities in copper-producing countries. The ICSG revised down its global mine and refined copper output by 950k MT and 1.1mm MT, respectively, for this year on the back of the COVID-19 pandemic.6 The group now expects 2020 mine supply to decline by 3% this year and refined production to remain flat y/y, for a second consecutive year. While important, these adjustments were insufficient to completely offset the large negative demand shock in 1Q and 2Q20.7 In 2H20, the supply-side outlook rests on the evolution of COVID-19 cases and associated governments’ responses in major ore and refined copper-producing countries (i.e. Chile, Peru, US, DRC, China, Russia, and Japan). So far, mining activities were mostly treated as essential and allowed to operate at reduced capacity under additional sanitary and social distancing guidelines. Confirmed cases in these countries appears to be slowing, this could allow activity to slowly return to normal (Chart 11). Chart 11Further Supply Disruptions Are Unlikely Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices.  While mining and refining of copper concentrates were often classified as essential, scrap activities were not. According to the ICSG, copper scrap supplied decreased significantly as trade flows and generation, collection, and disassembling activities were disrupted by the pandemic. China’s import of scrap copper – a key input for Chinese refiners – declined 37% in 1Q20. This prompted the government to allow more scrap imports to fill the gap, but it might struggle to find suppliers. Globally, scrap makes up ~ 25% of total refined copper supply, thus, it usually plays a non-negligible role in the rebalancing of global markets. Supply factors are for the most part reflected in current prices. Going forward the speed of the demand recovery will be the determining factor for copper prices. In addition, the crisis began at an abnormally low inventory level. Thus, despite the temporary build in 1Q20, inventories are still below their 2010 to 2019 average. The rebound in demand, combined with flat supply and limited scrap availability, will move Chinese inventory down in 2H20 and offset any builds at the LMEX and COMEX warehouses, supporting copper prices this year (Chart 12). Chart 12Inventories Still Low Despite Builds In 1Q20 USD Depreciation Leads To EM Economic Growth Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD. As the COVID-19 shock abates we expect a weaker US dollar to be more supportive to copper demand. Uncertainty over the duration of lockdowns globally continues to fuel safe-haven demand for USD (Chart 13). The shortage of USD experienced by EM debtors servicing dollar-denominated debt continues to hamper their recovery. The combination of safe-haven demand and a continued dollar shortage for borrowers without access to US swap lines is keeping the dollar well bid, suppressing foreign flows to EM economies and commodity demand at the margin (Chart 14, panel 1). Chart 13Global Financial Cycles Hurting EM Economies Chart 14Uncertainty Keeps USD Well Bid The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. EM economies – the bulk of base metals demand growth – are facing dual domestic demand and global financial shocks.8 These economies have become more dependent on foreign portfolio inflows, both in debt and equity markets (Chart 14, panel 2). Thus, global financial cycles now have a significant impact on their growth. The main factors influencing these flows are risk appetite, EM exchange rates, and DM interest rates.9 We expect all factors to support inflows to emerging markets as the COVID-19 shock abates. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions. A lower USD will decrease the local-currency cost of consuming commodities ex-US. Metals producers' ex-US will face higher local-currency operating costs, reducing supply growth at the margin. A depreciating USD is a necessary factor for our bullish cyclical commodities view (Chart 15). The risk to this view is a severe second wave of COVID-19 infection which would cause safe assets to spike anew. Chart 15Metals Inversely Correlated With The US Dollar $3.00/lb Copper Price Likely; Geopolitical Risks Mounting Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets.  For April, our copper demand model suggested prices were at equilibrium relative to underlying demand trends (Chart 16). Chart 16Copper Prices Will Rise As The USD Depreciates When simulating a 10% decline in the USD and a rebound in EM import growth in 2H20, our model suggests COMEX copper prices could move 25% higher, holding everything else constant. In reality, the USD’s path and the extent of the EM import rebound are among the key known unknowns we confront in estimating a model for copper prices. We do not have a precise view on these variables, which is why we run simulations. Theory would suggest the stimulus we are seeing globally points to a lower USD and a pick-up in EM imports, however, and these factors will create a more supportive environment for metals prices. Over the short term, geopolitical risks – chiefly mounting Sino-US tensions – could derail the rally in copper prices and other risk assets. With the US election now only 5 months away, President Trump’s odds of being reelected on the back of a strong economy are fading amidst the COVID-19 pandemic. According to our Geopolitical strategists, Trump is the underdog and will need to double down on foreign and trade policies to prop-up his chances of winning. Meanwhile, China is seeking to solidify its sphere of influence.10 This is causing US-China tensions to intensify. Depending on the nature of the actions taken by the Trump administration (i.e. increasing tariffs on US imports of Chinese goods vs. cutting China’s access to foreign technology), metals prices could suffer, as was the case in 2018. With these geopolitical risks in mind, we maintain that China’s strong fiscal and monetary stimulus, combined with a falling US dollar will provide a favorable backdrop for copper markets in 2H20.   Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Commodities Round-Up Energy: Overweight Doubts about OPEC 2.0’s commitment to extending their deepest-ever production cuts expiring this month to July, perhaps August, took some of the steam out of crude-oil rally earlier in the week. In our modeling, we do not see the need to extend the massive voluntary cuts announced by the Kingdom of Saudi Arabia (KSA) and its Gulf allies: KSA’s cuts of ~ 4.5mm b/d vs. its April output level of 12mm b/d starting this month will take the Kingdom’s output to ~ 7.5mm b/d. The UAE and Kuwait also voluntarily added cuts of 100k and 80k b/d, respectively, to their agreed quotas. We continue to believe the current schedule of production cuts will result in a physical supply deficit in 3Q20, which will require OPEC 2.0 to begin raising production to keep prices from getting too high going into a US presidential election. We expect Brent prices to average $40/bbl this year and $68/bbl next year, with WTI trading $2 - $4/bbl below that (Chart 17).11 Base Metals: Neutral Iron ore prices breached $100/MT this week, as COVID-19-induced supply disruptions in Brazil – the largest exporter of high-grade ore – and South Africa leave the seaborne market open to Australian suppliers to meet higher Chinese demand as port inventories are rebuilt. FastMarkets MB, a sister company of BCA Research, reported May exports to China from Brazil were down 28% y/y to 21.5mm MT from just under 30mm MT the year prior. Iron ore exports from Australia are expected to exceed A$100 billion this year, according to government estimates reported by the Financial Times.12 Precious Metals: Neutral As we go to press, gold prices retreated to $1,700/oz from ~ $1,740/oz last week, exhibiting a positive correlation with the dollar. This is a result of rising risk appetite globally as economies exit lockdowns. In the US, interest rates are continuing to support gold. Going forward, the probability of negative rates is remains low, but the Fed will continue to buy more debt from the public and private sectors to push the shadow rate further down. This supports gold prices (Chart 18). Chart 17Crude Prices Will Rebound Chart 18Fed Buying Supports Gold Prices     Footnotes 1     Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 2     A resurgence of infection triggered renewed lockdowns over a region of 100 million people in May. Please see More than 100 million people in China's northeast back under lockdown to thwart potential second wave published by the National Post on May 19, 2020. 3    Please see BCA's Emerging Markets Strategy Weekly Report "EM Stocks Are At A Critical Resistance Level," published May 28, 2020. It is available at ems.bcaresearch.com. 4    Please see BCA's China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," published May 28, 2020. It is available at cis.bcaresearch.com. 5    There remains a risk global monetary stimulus fails to ignite strong consumer and business consumption. The unprecedented shock could raise precautionary savings and keep risk aversion elevated for an extended period. Based on the Quantity Theory of Money, money supply times velocity (the rate at which money changes hands) equals nominal GDP. Low confidence translates to a low velocity of money limiting the reach of monetary policy. This value is extremely difficult to forecast. 6    Please see “The Impact of the COVID-19 Pandemic on World Copper Supply,” published by the International Copper Study Group on May 21, 2020. 7     According to BGRIMM Lilan Consulting, China’s real demand for refined copper declined by ~22% in 1Q20. This implies a ~11% decline in global copper consumption. Please see footnote 6 for more details. 8    Global financial cycles capture how global financial conditions affect individual economies. The analysis of these cycles stressed the importance of common factors in global risk asset prices which are driven by risk appetite and US monetary policy. These factors are mainly explained by developments in advanced economies but have a drastic effect on emerging markets. Please see Iñaki Aldasoro, Stefan Avdjiev, Claudio Borio and Piti Disyatat (2020). “Global and domestic financial cycles: variations on a theme,” BIS Working Papers, No 864. 9    Please see Chapter 3 of the Global Financial Stability Report titled “Managing Volatile Portfolio Flows,” published by IMF. 10   Please see BCA's Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," published May 29, 2020. It is available at gps.bcaresearch.com. 11    Please see our May 21, 2020 report entitled US Politics Will Drive 2H20 Oil Prices for our latest view on oil fundamentals and prices, available at ces.bcaresearch.com. 12    Please see Australia’s iron ore miners exploit supply gap as Covid-19 hobbles rivals published by the Financial Times June 3, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

The SPX has broken out to fresh recovery highs defying recent rising political and geopolitical risks. The reopening of the economy is the primary driver of renewed market euphoria, along with the ongoing easy fiscal and monetary policies. Sentiment is not as extended as at the February SPX peak or previous SPX peaks in the past few years. However, greed is slowly showing up on our radar screens as investors that have missed out on the rally are chasing performance and also there is an added element of a short squeeze. One potential negative catalyst that could cause a healthy reset is the rise in the polls of Democratic presidential candidate Joe Biden ahead of the November elections. The chart shows that over the past year the S&P 500 has moved in lockstep with the relative odds of a Republican versus a Democrat getting elected President. In truth, the online gambling community has been slow to react to the erosion of President Trump’s platform due to pandemic and recession – so his odds could fall further in the near term. At the margin, a Biden win should be negative for the stock market as he is perceived as more hostile to businesses and the specter of higher taxes could trip up the SPX. Our Geopolitical Strategy has highlighted this risk in recent reports, including on May 15.1 Bottom Line: While we remain constructive on the SPX over the coming 9-12 month time horizon, a flare in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities.   Footnotes 1Please see BCA Geopolitical Strategy Weekly Report, “Michelle, Amash, Trump, Biden” dated May 15, 2020, available at gps.bcaresearch.com

Highlights Risks assets have entered­ a FOMO-driven mania phase that could last for a few more weeks. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this mania phase runs out of steam.  We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. Within EM, local rates will perform well in both risk-on and risk-off phases. Feature The recovery in global risk assets has entered a fear-of-missing-out, or FOMO, mania phase. Like any mania, this one could last longer and go further than any fundamental analysis could presume. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy. Within EM, local rates offer the best risk-reward profile.  A recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. The global equity rally has taken place amid a shrinking forward EPS. The top panel of Chart I-1 demonstrates that even the ever-bullish bottom-up analysts have been cutting their expectations of the level of corporate 12-month forward earnings per-share. As a result, the global forward P/E ratio has spiked to a 18-year high (Chart I-1, bottom panel).   Chart I-1An Unprecedented Divergence: Surging Stocks Prices Amid Plunging Forward EPS Levels Chart I-2EM Forward EPS Level Has Been Falling Chart I-2 illustrates that the same phenomenon is true for EM equities. Their forward EPS has been contracting and their forward P/E has jumped to a decade high.  Any overdrive in asset prices without supporting fundamentals can last for a while but typically ends with a crash. This FOMO-driven mania is unlikely to be any different. It is fair to say that during the March carnage, many investors operated on a “sell now, think later” principle. Since the rally began, they have switched to a “buy now, ask questions later” attitude. As this rally persists, global stocks and credit will become overbought and expensive. At that point, any negative shock could produce a sharp pullback that would likely devolve into another nasty selloff as investors shift back to a “sell now, think later” mentality. The Narratives Driving The Rally The narratives supporting this mania are simple and seem to be both accepted and embraced by a growing number of investors. We agree with some and disagree with others: Economies around the world are opening, which will ensure that an economic recovery will follow. Our interpretation: Surely as confinement policies are eased, activity will improve. However, in our opinion, this should not come as a surprise to investors. This is especially pertinent for the trend-setting US stock market. With US equity valuations not particularly cheap, the market was never pricing in extended lockdowns. Hence, it appears strange to us that markets have so exuberantly cheered the reopening of the economy. Looking forward, the key to the medium-term (six-month) equity outlook is the shape of the recovery following the initial partial normalization. The latter presently looks V-shaped because as stores and businesses reopen economic activity is bound to improve. Yet the odds are that following this initial normalization, the shape of the recovery is most likely to be U-shaped. For what it’s worth, manufacturing PMIs in export-oriented economies like Korea, Japan and Taiwan made new lows in May (Chart I-3). We are not suggesting these indicators will not improve in the months ahead; they surely will. Nevertheless, a marginal rise in diffusion indexes like PMIs from extraordinary depressed levels do not signify a profit recovery. This recession differs from previous ones as the level of business activity has dropped below breakeven points for more businesses than it did in other recessions. When a company operates below its breakeven level, a marginal rise in sales may not be sufficient to improve its debt-servicing capacity, hiring and capital spending intentions. However, it seems markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. This is why we feel risk assets are in a FOMO-driven mania phase, where fundamentals do not matter. Authorities around the world are stimulating, with the US pumping enormous amounts of fiscal and credit stimulus into the economy (Chart I-4, top panel). Chart I-3Asian Manufacturing PMIs Made New Lows In May Chart I-4An Unparalleled Global Money Boom   Chart I-5China Is Ramping Up Stimulus China has finally embarked on aggressive stimulus. The National People’s Congress has set the monetary policy objective for 2020 as follows: Substantially accelerate the growth of broad money supply and total social financing (Chart I-4, bottom panel). Our interpretation: Indeed, government stimulus worldwide is massive. Yet, it is hard to know if it will be sufficient to produce a V-shaped recovery. The rise in money supply at the moment is being offset by the drop in the velocity of money. As a result, nominal GDP levels are extremely low. That said, last week we upgraded our growth outlook for China because of the above-mentioned aggressive policy stimulus. It is possible that China’s credit and fiscal impulse will reach about 15% of GDP before year-end (Chart I-5). What presently deters us from recommending outright long positions in China-related plays is the escalating US-China confrontation and the risk of a relapse in global stocks. Central banks around the world both in DM and EM are monetizing debt and injecting immense liquidity into the system. Our interpretation: Correct, but equally relevant is investors’ animal spirits. The latter will determine whether and when these liquidity injections leak into risk assets. For now, it seems that once again central banks’ actions have been successful in lifting asset prices, despite poor fundamentals. Equity valuations are cheap, especially outside the US. This is especially true given the low risk-free rate. Our interpretation: We agree that EM equities are cheap, something we have been highlighting since mid-March (Chart I-6). Yet valuations are not a good timing tool, as they can stay depressed so long as profits are not worsening.  Meanwhile, US equities are expensive (Chart I-7). Critically, we argued in a recent report that equity multiples depend not only on the risk-free rate but also on the equity risk premium (ERP). Chart I-6EM Equities Are Cheap Chart I-7US Stocks Are Expensive   Given the immense ambiguities investors are facing with respect to both the business cycle and economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. In this context, US equity valuations are rather expensive, despite the very low risk-free rate. In short, the expensive US stock market has until very recently been the locomotive of this rally. If US share prices had not rallied hard in the past two months, EM and other international bourses would not have caught a bid. The Fed’s public debt monetization is a structural, not near-term negative for the greenback. The US dollar is expensive and will depreciate a lot due to unrestrained fiscal and monetary stimulus in the US. Our interpretation: The US dollar is one standard deviation expensive (Chart I-8) and EM currencies have become cheap (Chart I-9). Chart I-8US Dollar Valuations Are Elevated Chart I-9EM Currencies Are Cheap   Chart I-10EM Currencies And Stocks Correlate With Industrial Metals We do not disagree with the view that the US dollar is vulnerable in the long term due to the Federal Reserve’s aggressive debt monetization and that the Fed will eventually fall behind the inflation curve. Yet inflation is not imminent, and the Fed’s public debt monetization is a structural, not near-term negative for the greenback. As such, these potholes for the US dollar may not be pertinent in the next several months. Critically, Chart I-10 illustrates that EM currencies move with industrial metals prices, and EM stocks correlate with global materials stocks. The common driver of all of these markets is global growth in general and China’s industrial sectors in particular. In short, a recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. Investors are underinvested in global equities in general and cyclical plays in particular. Our interpretation: Indeed, we showed last week that institutional equity investors had been skeptical of this rally. What has driven or supercharged this equity rally since late March has been unsophisticated retail investors. They have been opening up broker accounts worldwide and aggressively trading since March lockdowns. We cited a few pieces of anecdotal evidence confirming this phenomenon in last week’s report.  However, it seems that institutional investors in recent weeks have capitulated by raising their risk exposure in general and their exposure to cyclical plays in particular. This explains the recent surge in cyclical equities and currencies.  Bottom Line: The narratives driving this rally are only partially correct. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this FOMO-driven mania phase runs out of steam.  Nuances To Beware Of There are several nuances about the market’s internals and characteristics that we would like to draw investors’ attention to: There is mixed evidence as to whether China’s economy in general and its industrial sectors in particular have entered a sustainable recovery. First, examining the Taiwanese manufacturing PMI data could help in assessing the growth outlook for both the mainland economy and for global trade. The basis is that Taiwan has done extremely well by avoiding COVID-19 outbreaks and lockdowns. Therefore, there are no domestic reasons for weak output growth. In addition, its manufacturing sector is very export-oriented, with about 40% of exports destined for mainland China. PMI export orders for Taiwan's aggregate manufacturing and its three key sectors plunged to new lows in May (Chart I-11). This includes both the electronic optical (semiconductor) and basic materials sectors. The latter correlates well with global materials stocks. There has so far not been a bullish signal from this indicator (Chart I-11, second panel).    Second, China’s domestic A-share market in general and its cyclical sectors in particular have not yet broken out (Chart I-12). Given China was the first nation to exit from lockdowns, its share prices should be the first to signal a sustainable economic recovery. Yet onshore share prices have been rather subdued. China’s economy will eventually stage a recovery later this year. Our point is that global cyclicals might have run ahead of themselves by pricing in a recovery too early. Chart I-11Taiwanese Manufacturing PMIs In May: New Lows Across All Industries Chart I-12Chinese Onshore Share Prices Are Not Flagging An Imminent Recovery   Equity market and sector leadership changes occur during selloffs or at the inception of rallies.  Chart I-13 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM. And all of them occurred during selloffs in global share prices. Chart I-13EM Versus DM Equity Leadership Rotations Took Place During Selloffs Similarly, the relative performance of global growth versus value stocks experiences trend reversals during global bear markets (Chart I-14). Chart I-14Global Growth Versus Value Leadership Rotations Occurred During Bear Markets Chart I-15EM Could Outperform DM For A Few Weeks Leadership of US equities and global growth stocks did not change during the March crash nor during the following two-month rally from the bottom. Only in the past week or so have US equities and global growth stocks begun to lag EM bourses and global value, respectively (Chart I-15). In brief, the latest leadership rotation from US to EM did not occur during the selloff or at inception of the rally – i.e., it does not fit the typical profile of sustainable leadership reversal. As such, it may not be enduring. The internals of this rally are consistent with the fact that it might already be at a late stage. During rallies, laggards are the last to catch a bid. Contrarily, during selloffs, outperformers are the last to be liquidated. For example, US growth stocks were the last ones to be liquidated in both the 2015-early-2016 and 2018 selloffs. When the decade-long leaders – US growth stocks – were finally stamped out, it marked the bottom of those selloffs. We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Using an analogous framework for this rally, the latest extraordinary spike in the laggards such as EM, Europe and both value and cyclical stocks could be a sign of bear capitulation, and could signify the final phase of this equity rally.  Bottom Line: There are several nuances to the current equity market rally, but investors seem reluctant to consider them amid a FOMO-driven mania. Investment Considerations The FOMO-driven rally could last for several more weeks. Afterwards it will be followed by a major setback. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy.  Chart I-16EM Local Rates Offer Value We are making the following adjustments and changes to our strategy and trade recommendations: In regard to our EM versus DM asset allocation strategy, we are making one change: we are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Consistently, we are closing two positions: (1) our short EM corporate and sovereign credit / long US investment-grade corporate bond trade; and (2) our long Asian investment-grade /short high-yield corporate bond trade. Within the EM credit space, we continue to favor sovereigns versus corporates – a strategy recommended on April 23. We are still reluctant to strategically upgrade EM stocks versus DM ones even though odds of EM outperforming DM stocks are high in the coming weeks. In light of the potential FOMO-driven rally, to protect profits we are closing the following two currency positions: Take profits on short BRL/long USD trade. It was initiated on November 29, 2019 and has produced a 19% gain. Book profits on short SGD/long JPY position. This recommendation has generated a 2.3% gain since its initiation on June 8, 2018. We are still maintaining shorts in the following EM currencies: CLP, ZAR, TRY, IDR, PHP and KRW. They could continue rallying in the near term but will relapse afterwards. We are also structurally short low beta currencies: the RMB and the Saudi riyal. Within EM, local rates offer the best risk-reward profile: they will perform well in both risk-on and risk-off phases. Real bond yields remain somewhat elevated in many EMs, as shown in Chart I-16. We continue to receive long-term rates in Mexico, Colombia, Russia, Ukraine, India, Pakistan, Malaysia, China and Korea, as well as 2-year rates in South Africa. Their central banks will reduce policy rates much further. In addition, several of these local bond markets will benefit from ongoing quantitative easing by their central banks. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (see chart). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium. Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical 9-12 month time horizon. For a detailed discussion on inflationary forces and their effects on the S&P 500 GICS1 sectors, please refer to this Monday’s Special Report.