Developed Countries

Feature For a decade, mainstream economics has prescribed remedies for sluggish growth in the euro area on the basis of three articles of blind faith. First, that the ailment arises from structural impediments to growth; second, that in response to an ailing economy, ultra-loose monetary policy is always and everywhere effective; and third, that ‘Keynesian’ government stimuluses are at best a necessary evil and at worst a recipe for disaster. As a result, European policymakers have expended much time and energy attempting structural reforms, experimenting with ultra-loose monetary policy, while shirking government borrowing and spending. But have policymakers misdiagnosed the ailment? Chart of the WeekItaly’s Private Sector Is Paying Back Debt Why The Focus On Public Deficits And Debt Might Be Misplaced We frown upon government deficits. They are associated with crowding out and misallocation of resources. But when the private sector is running a financial surplus, the exact opposite is true. Government borrowing and spending causes no crowding out because the government is simply utilising the private sector’s surplus savings and debt repayments. And importantly, this deficit spending prevents a deflationary shrinkage of the broad money supply. Most people are aware of the size of government deficits. Few people are aware of the size of private sector surpluses; and the leakage from the national income stream that they create. By not making this connection, people might believe that government deficits are profligate. But if the private sector as a whole has a financial surplus, it makes sense for the government to borrow to support economic growth. In a similar vein, an economy’s debt sustainability depends on its total indebtedness, not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. This is also the point at which lenders tend to be unwilling to provide the marginal loan. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. Deficit spending can prevent a deflationary shrinkage of the broad money supply. It does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. Many people believe that Italy has one of the world’s most indebted economies. But this belief is wrong. Although Italy’s public indebtedness is high, Italy’s private indebtedness is one of the lowest in the world, making Italy’s total indebtedness less than that of France and the U.K., and broadly equal to that of the U.S. (Chart I-2-I-5). Crucially, Italy’s extremely low private indebtedness means that it could afford relatively high public indebtedness before reaching the limit of debt sustainability. Chart I-2Italy: Total Debt = 250% Of GDP Chart I-3France: Total Debt = 315% Of GDP Chart I-4U.K.: Total Debt = 280% Of GDP Chart I-5U.S: Total Debt = 250% Of GDP   Italy And Japan: Compare And Contrast In a normal world, the task of ensuring that private sector savings are borrowed and spent falls on the banks, which take in the savings and debt repayments and lend them out to others in the private sector who can make the best use of the funds. But if a dysfunctional banking system fails this task, the savings generated by the private sector will find no borrowers. The unrecycled funds become a leakage from the national income stream generating a persistent deflationary headwind for the economy. Welcome to Italy! Since 2008, the stock of loans to Italian households and firms has been stagnant while in real terms it has fallen (Chart of the Week). The upshot is that the real money supply has shrunk despite low private sector indebtedness, low interest rates and massive injections of ECB liquidity into the banking system. Japan’s public sector levering has been counterbalancing its private sector de-levering. After the 2008 global financial crisis Italian banks’ balance sheets were left unrepaired and undercapitalized. For an individual bank whose solvency is impaired, the right thing to do is shrink its loan book relative to its equity capital. But when the entire banking system is doing this simultaneously, the economy falls into a massive fallacy of composition: what is right for an individual bank becomes very deflationary when all banks are doing it together. Under these circumstances, an agent outside the fallacy of composition – namely, the government – must counter this deflationary headwind by borrowing and spending the un-recycled private sector savings. Welcome to Japan! The Japanese government has been doing precisely this for the past 25 years. Many people fret about the Japanese government’s persistent deficits and its ballooning public debt. What these people do not realise is that these persistent deficits are simply counterbalancing private sector de-levering. Hence, Japan’s all-important total (public plus private) indebtedness as a share of GDP has not been rising (Chart I-6). In Italy, the banking system has been dysfunctional for over a decade, preventing the private sector from borrowing (Chart I-7). Under these circumstances, the Italian government could borrow the private sector’s excess savings and debt repayments and put them to highly productive use, just like in Japan. Chart I-6Japan’s Persistent Deficits Have Been Counterbalancing Private Sector De-levering Chart I-7The Italian Banking System Has Been Dysfunctional Japan and Italy have quite similar demographics, but there is also a big difference. Despite the Japanese government’s persistent deficit and ballooning debt, the 10-year Japanese government bond seems not the slightest bit concerned and is yielding zero. Whereas in Italy, where the government finances are close to structural balance, the merest hint of a Keynesian stimulus sent the 10-year BTP yield rocketing towards 4 percent. Why? The answer is that Italy does not have its own central bank. The Japanese government bond yield is a direct function of the BoJ’s expected monetary policy. But the Italian BTP yield has two components: the ECB’s expected monetary policy plus a risk-premium for currency redenomination in the event that Italy left the euro. Italy’s problem is that even if modest deficit spending was the right policy, it would take time to prove. Meanwhile, bond vigilantes shoot first and ask questions later. The euro debt crisis was essentially a fear of currency redenomination which resulted from bond vigilantes running amok. When bond markets refuse to lend to sovereigns at a rational interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government’s finances. Thereby, the fear of redenomination could become a self-fulfilling prophecy. In Italy, the banking system has been dysfunctional for over a decade. The bottom line is that every economy has its own ‘tipping-point’ interest rate, at which its debt financing can flip from stability to instability. But we believe this interest rate is low everywhere. Modern Monetary Theory Simplified Modern Monetary Theory (MMT) is a hot topic of the moment. Our view is that its breakthrough is to establish the ‘appropriate’ public sector deficits in the context of private sector surpluses, and it simplifies to this question: In highly indebted economies, what is the interest rate needed to keep total (public plus private) indebtedness as a share of GDP stable, and prevent a deflationary shrinkage of the broad money supply? The answer differs slightly from economy to economy because private sector indebtedness is modestly rising in some places, stable in a few, while declining in others (Chart I-8).  But crucially, at a global level, total indebtedness is stabilising with the global bond yield within a historically depressed sideways channel (Chart I-9). Chart I-8Private Sector Indebtedness Is Not Rising As A Whole Chart I-9The Global Long Bond Yield Has Been In A Sideways Channel Admittedly, the global bond yield is now at the bottom of this channel. This means that from a tactical perspective, we can expect 10-year yields to go up about 50 bps before hitting the top of the channel. However, from a structural perspective, the interest rate needed to stabilise total indebtedness as a share of GDP now appears to be extremely low. And this means that structurally low bond yields are here to stay. Finally, I am excited to report that two of the main commentators on MMT – Richard Koo and Stephanie Kelton – are keynote speakers at our annual conference on September 26-27 in New York City. Suffice to say it will be an event not to be missed! Fractal Trading System* There are no new trades this week, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Underweight We downgraded the S&P railroads index to underweight last month based on falling rail traffic leading railroad pricing power down from its recent highs. Last week’s release of traffic data showed further deterioration in volumes, the fundamental driver of pricing power, confirming our bearish thesis. Only four of the 20 commodity categories tracked by the Association of American Railroads (AAR) saw volumes increase last month and virtually all of this was petroleum products which itself is likely only a temporary gain, owing to easing in pipeline bottlenecks later this year. Overall traffic fell a stunning 5.2% from the same period last year (third panel). The Cass Freight Shipments Index too has recently rolled over, a likely precursor to a fall in the Expenditures component of the index, and predicting that railroad pricing challenges are in the early stages (second panel). Meanwhile, sector leverage ratios are at their highest level in a decade as railroads have retooled their capital structure to increase buybacks at the expense of the balance sheet, adding a new level of risk to the industry (bottom panel). Bottom Line: Valuations in the S&P railroads index have overstated earnings power and understated equity risk premia; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. ​​​​​​​

Lumber is a hyper-sensitive variable that has historically moved in lockstep with the SPX, its momentum (bottom panel) and of course EPS. Lumber’s leading properties are tied to the housing market link and the recent plunge in lumber futures is disconcerting. The top panel of the chart shows that lumber peaked in mid-May and then the SPX followed suit in late-September. Similarly, lumber troughed in late-October again leading the SPX trough. Currently this economically sensitive indicator is not confirming the bullish SPX run as it peaked in early February. We reiterate our view held since early-March that at least some short-term equity market caution is warranted, especially given the negative EPS backdrop on the eve of earnings season.      

Special Report

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout Table 3CFIUS Is Mostly About China The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict.   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

In Monday’s Special Report, we answered clients’ most frequently asked questions from our recent marketing trip to the old continent. Front of mind for most of our clients was the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate and especially the implications of the inversion for sector positioning and the duration of the business cycle. From an equity strategy point of view, we are focused on the SPX’s performance following the yield curve inversion and, within that framework, the appropriate sectoral positioning therein. In mid-December last year we showed the results of our research and made a simple observation that the 10/2 yield curve inversion (which, importantly, has not yet occurred) almost always takes place prior to the S&P peak.1 In Monday’s Special Report, we broadened this analysis to show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in the table below. While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Please see our Special Report for answers to other client questions.   1      Please see BCA U.S. Equity Strategy Weekly Report, “ Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com.