Canada

Highlights Currency markets remain vulnerable to the upcoming US election, Brexit, and a resurgence of Covid-19 infections. Meanwhile, President’s Trump suggested “piecemeal” fiscal deal increases the odds of a correction in the near term. Stay short USD/JPY as a core holding. We eventually expect the passage of a fiscal deal, regardless of who is in the White House. This will favor pro-cyclical trades. CAD/USD is likely to continue strengthening versus the dollar, but underperforming at the crosses. The key reason is that, in the short term, even with an oil price recovery, Canadian crude will remain trapped in Alberta, keeping the WCS-to-WTI discount wide. Meanwhile, domestically, while the Canadian economy has bottomed, a resurgence in new Covid-19 cases puts this recovery at risk. We therefore expect the loonie to touch 80-82 cents but underperform the Australian dollar, Swedish krona, and Norwegian krone. Go short CAD/NOK for a trade. Feature Chart I-1The CAD Has Been A Laggard Since the DXY index peaked on March 19, the Canadian dollar has been an underperformer. Among its G10 peers, only the safe-haven currencies such as the Swiss franc and Japanese yen trail behind the loonie. This is remarkable since other commodity currencies such as the Norwegian krone and Australian dollar have posted very handsome returns since the March lows (Chart I-1). The natural question is whether the loonie’s underperformance is a sign of mispricing, or if other fundamental factors are at play? If the latter, then what are the key drivers of this underperformance and what sort of returns can we expect from the loonie over the next six to 12 months? Finally, are there any opportunities at the crosses that investors can capitalize on? The Loonie: Key Drivers The key drivers of the Canadian dollar are what happens to natural resource prices, specifically crude oil, and the Bank of Canada’s monetary policy stance relative to the Federal Reserve. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. This is because rising domestic income from higher oil prices boosts aggregate demand. This comes both from the private sector through increased capital spending, more hiring and increased wages, and from government spending afforded by higher tax revenues and royalty income. As a result, the higher aggregate demand provides room for the BoC to hike interest rates. As a major oil-producing nation, it is well known that an important driver of the loonie has been the price of crude oil. Meanwhile, an increase in oil prices also implies rising terms of trade. This improves balance-of-payment dynamics, allowing the fair value of the exchange rate to rise in the process. As such, the rise in the currency does not necessarily tighten financial conditions. It is quite remarkable that for most of the last two decades, the difference between Canadian and US interest rates can be explained by swings in the oil price. This in turn has been a powerful driver of the Canadian dollar (Chart I-2). Chart I-2Policy Rates Follow The Oil price Chart I-3A Significant Resource Sector In Canada This should not come as a surprise. As a share of GDP, resources account for almost 20% of the Canadian economy (Chart I-3). The share of commodity exports is also a quite significant at 23%. While the share of services in the economy has risen, much of this is in the orbit of mining and oil and gas extraction support services. In a nutshell, the Canadian economy remains a resource-based one, making the outlook for resources, specifically crude oil, an important consideration. Where To Next For Canadian Crude? The oil industry has been hit by multiple tectonic shocks, including a sudden stop in economic activity, a fallout from the OPEC cartel, divestment from ESG funds, and falling oil intensity in many economies. Just over a decade ago, the price of crude oil was firmly above $100 per barrel. Fast forward to today and many blends are trading south of $45 per barrel (Chart I-4). Chart I-4Many Blends Are Trading Below Going forward, the path for oil prices will be highly dependent on the interplay between demand and supply. Oil demand tends to follow the ebbs and flows of the business cycle, with over 60% of global petroleum consumed by the transportation sector. As a result, crude oil prices have largely tracked Apple mobility data (Chart I-5). Many countries are now entering renewed restrictions due to the second wave of the pandemic, which is showing up in a slowdown in traffic. However, as we discussed last week, the economic effects should be far less lethal that what we experienced in the first half of this year. The reasons include the potential for a vaccine soon and a substantial drop in mortality rates. Our commodity strategists expect oil prices to average $65 per barrel next year, much more than is currently priced in the futures curve. Crude oil prices have largely tracked Apple mobility trends data.  From a bird’s-eye view, oil prices are more likely to enter a broad trading range, as they did in the ‘80s and ‘90s, than a structural bull market. On the positive side, we have probably seen a bottom in oil prices, in that it is unlikely we will revisit negative price territory. However, history suggests that it takes quite a long time for excesses to clear in the oil market. The bull market of the 1970s was followed by a 20-year bear market, as OPEC production surged (Chart I-6). This time around, US shale production has gained significant market share, and with the electrification of the modern economy, a lot of barrels may need to be taken off the market to induce a genuine bull market. Chart I-5Oil Prices Have Tracked The Recovery In Traffic Chart I-6A Secular View On ##br##Oil Prices Canadian players suffer from two additional hiccups: First, the International Maritime Organization has introduced new standards for bunker fuel since January 2020 (IMO 2020). According to the new standards, sulphur content must be cut from 3.5% to 0.5%. Canada’s Western Canadian Select (WCS) blend is one of the world’s heavier crudes with a sulphur content north of 3.5%. This is expected to significantly widen the discount between WCS and light sweet crude. This is bad news for Canadian oil producers. Second, pipeline capacity remains a major hurdle to getting Canadian crude to US refineries. This leads to a transportation discount for Canadian crude oil. The Enbridge Line 3 replacement is facing delays from the state of Minnesota (390K additional barrels). The future of the Keystone XL pipeline, a major release valve for Canadian oil (830K barrels a day in capacity), rests on the US election. Former Vice President Joe Biden has opposed the project, calling Alberta’s oil “tar sands that we don’t need.” The Trans Mountain Expansion project (690K additional barrels), connecting Alberta to the Westridge Marine Terminal and Chevron refinery in Burnaby, is slated to be competed only by the end of 2022. All this could widen the discount between WCS and WTI crude oil, hurting the Canadian dollar in the process (Chart I-7). There are offsetting factors. The drop in Venezuelan oil production has allowed Canadian producers to gain market share in the heavy crude oil market. Production cuts in Alberta have also helped mitigate the oversupply of heavy crude. Canadian oil exports are near record highs, despite the fact that the US is rapidly becoming energy independent (Chart I-8). As a share of imports, Canadian crude represents about half of the US’s intake (Chart I-9). This highlights the importance of heavy crude in oil market dynamics. Specifically, a lot of refining capacity in the US has been fine-tuned to handle the cheaper but heavier blend from Canada. Chart I-7Canadian Oil Discount Could Widen Chart I-8Big US Demand For Canadian Oil Chart I-9Big US Demand For Canadian Oil Netting it all out, we will expect crude oil prices to head to $65 per barrel, while the Canadian discount to widens to $20 per barrel before slowly recovering. This should provide modest upside for the Canadian dollar as terms of trade continue to improve. A Regime Shift Chart I-10Oil Production: US Versus Canada There has been a paradigm shift in oil production, with US shale producers aggressively grabbing market share from both OPEC and non-OPEC producers. Currently, Canada produces only 5.5% of global crude versus 15% for US production. Admittedly, the Canadian market share has also been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie (Chart I-10). In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around 2010 when US production was about to take off. Since then, that correlation fell from around 0.9 to about 0.2 (Chart I-11). The loss of shale output during the recent downturn has somewhat re-established a strong correlation between petrocurrencies and the crude oil price (bottom panel). But more importantly, should global demand pick up, US shale output will rise again and redistribute market share away from both OPEC and other non-OPEC members and towards the US. Chart I-11Negative Correlation Between Petrocurrencies And Crude Oil Restored Take the Mexican peso as an example. Since 2013, Mexico has become a net importer of oil, as the US moves towards becoming a net exporter. This explains why the positive correlation between the peso and oil prices has weakened significantly in recent years. Put another way, rising oil prices benefit US domestic income much more than they did in the past, while the benefits for countries like Canada and Mexico are slowly fading. The Canadian crude market share has been rising, but the tectonic shift in US production has severely dampened the positive correlation between crude prices and the loonie.  The second seismic shift in oil markets has been the ESG wave. With awareness towards global warming and climate change gaining mainstream support, divestments from energy assets has picked up steam. Currency markets react to net portfolio flows, and divestments from the energy sector in particular and the commodity sector in general have been behind the huge underperformance of the Canadian dollar since 2011 (Chart I-12). Chart I-12Huge Underperformance Of Canadian Equities The good news is that a lot has already been priced in. First, global energy stocks have been in a 12-year bear market in relative performance terms. This represents a 70% peak-to-trough decline, with the latest selloff being symptomatic of a capitulation phase. Second, at a price-to-book discount of 64% and a dividend yield of 7%, energy stocks are very cheap (Chart I-13). Chart I-13A Capitulation In Energy Stocks? It is remarkable that long-term portfolio flows into Canadian assets have started picking up, a sign of bargain hunting by international investors (Chart I-14). This should provide a modest tailwind to the Canadian dollar over the next six to 12 months. Chart I-14A Recovery In Canadian Portfolio Inflows Improving Domestic Conditions The Canadian domestic economy has been holding up well, despite lower oil prices. This has occurred on the back of massive fiscal stimulus, in addition to the BoC dropping rates to 0.25% and engaging in quantitative easing. During his Throne Speech a fortnight ago, Canadian Prime Minister Justin Trudeau vowed to do “whatever it takes” to support people and businesses throughout the crisis. Fitch Ratings estimates that the budget deficit in Canada will remain wide going into 2022 (Chart I-15). Meanwhile, as lockdown measures have eased since April, incoming data has been robust. Chart I-15Lots Of Fiscal Stimulus In Canada Canada continues to create record employment, with 246,000 new jobs added in August. This is leading to the fastest recovery in the unemployment rate on record (Chart I-16). The manufacturing and resources sectors in Quebec, Alberta, and British Columbia, which bore the brunt of the employment declines, are rebounding. Chart I-16Best Job Recovery In Decades Most measures of household confidence are in a V-shaped recovery. Retail sales in Canada have rebounded, reaching above pre-pandemic levels. Mortgage credit has also picked up strongly. Correspondingly, housing starts have overtaken their pre-pandemic peak as well, with new home construction at its highest level since 2007. Working from home has led to a surge in renovation projects. Meanwhile, low rates and rising home prices have encouraged new construction. Residential investment is almost 7% of Canadian GDP, a significant chunk of aggregate demand (Chart I-17). Despite the improvement in domestic conditions, inflationary pressures remain moribund. The output gap measure according to the BoC remains wide at -3.2% of GDP. The latest inflation print shows that domestic prices in Canada still remain anchored below the midpoint of the BoC’s target band. This means that the BoC will be in no rush to normalize policy anytime soon (Chart I-18). Chart I-17Residential Construction Is Important Chart I-18Canadian Inflation Is Below Target Given the government’s commitment to step in as a spender of last resort, real rates in Canada will remain depressed as inflation starts to recover. This will not be as pronounced versus the US, where the Fed is trying to asymmetrically generate inflation, but more so against its commodity peers such as Australia and Norway, where the number of new Covid-19 cases remains under control, giving the governments there less incentive to significantly increase spending. This suggests that while the loonie may have upside against the dollar, it could underperform at the crosses. Investment Implications We expect the CAD/USD to gravitate higher in the next few months. The key catalysts are favorable interest rates versus the US and a gradual recovery in WCS oil prices as global economic activity picks up. From a fundamental perspective, the CAD is still undervalued by 7.3% on a trade-weighted basis (Chart I-19). This puts 80-82 cents within striking distance. Chart I-19The CAD Is Still Cheap Chart I-20Sell CAD/NOK Relative to other commodity currencies, transportation bottlenecks in Canada will prove to be a formidable hurdle in closing the current discount between WCS and WTI and/or Brent. While Canadian crude is likely to remain trapped in the oil sands for now, North Sea crude will face fewer transportation bottlenecks in the near term. This suggests that the path of least resistance for the CAD/NOK is down (Chart I-20). Sell CAD/NOK for a trade. An improvement in economic activity in Asia relative to the West will also favor AUD/CAD. Rising oil prices are a terms-of-trade boost for oil exporters but lead to demand destruction for oil importers. In general, a strategy for playing oil upside is to be long a basket of energy producers versus energy consumers. This suggests that the CAD has upside against the euro, the Indian rupee, and the Turkish lira. We are already long a basket of petrocurrencies versus the euro. Finally, we are long CAD/NZD as a play on policy divergences between the Reserve Bank Of New Zealand and the BoC. However, our conviction on this trade is low due to the resurgence of new cases in Canada. We recommend maintaining tight stops on this position.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: The unemployment rate fell from 8.4% to 7.9% in September. Nonfarm payrolls increased by 661K. The ISM Non-manufacturing Index increased from 56.9 to 57.8 in September. The Michigan Consumer Sentiment Index jumped from 74.1 to 80.4 in September. The trade deficit widened from $63.4 billion to $67.1 billion in August. Initial jobless claims increased by 840K for the week ending on October 3. The DXY index fell initially but then recouped the loss, ending flat this week. Trump’s tweet on Tuesday about “halting COVID-19 relief talks until after election” largely reduced the likelihood of any imminent fiscal stimulus. While pre-election uncertainties have been dominant recently, we remain dollar bears in the cycle, especially in a post-election and post-vaccine world. Report Links: Tail Risks In FX Markets - October 2, 2020 The Message From Dollar Sentiment And Technical Indicators - Sept. 25, 2020 Addressing Client Questions - September 4, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation declined from -0.2% to -0.3% year-on-year in September. Core inflation also decreased from 0.5% to 0.2%. The Markit Services PMI edged up from 47.6 to 48 in September. The Sentix Investor Confidence Index increased from -9.5 to -8.3 in October. Retail sales grew by 3.7% year-on-year in August. The euro rose by 0.2% against the US dollar this week. The slip in core inflation this week reinforced the concern about deflation. In the recent strategic review, Christine Lagarde kept a dovish tone and reiterated a desire to keep policy accommodative. We believe that the PEPP with a total envelope of €1,350 billion through the end of June 2021 will continue to support euro area economic recovery. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: The Jibun Bank Services PMI increased from 45 to 46.9 in September. The current account surplus surged from ¥1.5 trillion to ¥2.1 trillion in August. The Eco Watchers Survey Outlook Index increased from 42.4 to 48.3 in September. The Current Conditions Index also grew from 43.9 to 49.3. The Japanese yen declined by 0.3% against the US dollar this week. Incoming data confirms that the Japanese economy is recovering from pre-pandemic lows. Apart from being a cheap safe-haven hedge, the Japanese yen is also supported by lower COVID infection rates and fewer political uncertainties. Stay short on USD/JPY. 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 from the UK have been positive: The Markit Services PMI increased from 55.1 to 56.1 in September. House prices grew by 2.3% year-on-year in July. Unit labor costs surged by 27.4% year-on-year in Q2. The British pound has been flat against the US dollar this week. Despite ongoing Brexit chaos, the pound managed to remain well above 1.27 in recent months. Our bias is that a Brexit deal will eventually be reached. We favor the British pound relative to the euro since the pound is tremendously undervalued against the euro. Besides, risk reversals also suggest that the pound is deeply oversold. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been mixed: The Commonwealth Bank Services PMI increased from 50 to 50.8 in September. Exports declined by 4% month-on-month in August while imports expanded by 2%. The trade surplus narrowed from A$4.65 billion to A$2.6 billion.   The NAB Business Confidence Index increased from -8 to -4 in September. The Australian dollar fell by 0.3% against the US dollar this week. On Tuesday, the RBA kept its interest rate steady at 0.25%. Governor Philip Lowe acknowledged the weakness in Australia’s labor market and highlighted that the RBA continues to consider various measures designed to support job growth as the economy opens further. We remain positive on the Australian dollar. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ Business Confidence Index improved from -28.5 to -14.5 in October. The Activity Outlook index also shifted from -5.4 to 3.6 in October. The New Zealand dollar fell by 1.1% against the US dollar this week. While still well below pre-pandemic levels, the ANZ Business Confidence Index has undoubtedly improved in October. Investment and employment intensions both moved higher, lifting profit expectations. That said, the services sector is still under severe pressure resulting from strict lockdown measures. Markets are now pricing in a higher than 50% probability of a further rate cut by early next year, which contributes to the relative weakness in the New Zealand dollar. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: The trade deficit marginally narrowed from C$2.53 billion to C$2.45 billion in August. The Ivey PMI declined from 67.8 to 54.3 in September. Housing starts increased by 209K in September, down from 261.5K in the previous month. The Canadian dollar appreciated by 0.3% against the US dollar this week. As an important oil producer and exporter, the Canadian dollar shifts along with the price of oil. In this week’s report, we discuss the key drivers behind the Canadian dollar and discover why it has underperformed other G10 pro-cyclical currencies. Please refer to our front section for more detailed research. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Total sight deposits continue to increase from CHF 704.5 billion to CHF 705.1 billion for the week ending on October 2. The unemployment rate declined from 3.4% to 3.3% in September. The Swiss franc appreciated by 0.2% against the US dollar this week and nearly 6% since January. The unwanted appreciation has been a headache for the SNB, which warrants more intervention against a pricey franc. Interestingly, the franc has been flat against the euro year-to-date. We are looking to buy EUR/CHF on weakness due to the SNB’s intervention and the CHF’s lower beta to growth. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been positive: The industrial production index increased by 1.1% month-on-month in August.  Manufacturing output increased by 3% month-on-month in August. The Norwegian krone rose by 0.7% against the US dollar this week. Incoming data from Norway is consistent with the recent economic recovery there, especially in the resources sector. Industrial production of mining and quarrying, basic metals, and machinery equipment jumped, respectively, by 10.1%, 8.8% and 15.7% month-on-month in August. We continue to favor the Norwegian krone and are looking to purchase the Nordic basket again at a more favorable price. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: Industrial production increased by 0.2% year-on-year in August, or 7% month-on-month. Manufacturing new orders was unchanged year-on-year in August, but that’s up from a 6.9% contraction in the previous month. The budget balance shifted from a surplus of SEK 19.8 billion to a deficit of SEK 13.1 billion in September. The Swedish krona increased by 0.6% against the US dollar this week. As a bellwether of global growth, Swedish manufacturing activity is one of the indicators we monitor closely in order to gauge where we are in a cycle. Despite recent uncertainties, the Swedish manufacturing sector is showing budding signs of recovery, which is bullish for the Swedish krona. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Chart 12New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

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