Developed Countries

Underweight (High-Conviction) When we lowered our recommendation to underweight and added the S&P interactive media & services index to the high-conviction underweight list for 2019,1 we noted that one of our key themes for the year ahead would be increasing regulatory efforts on technology. This theme has accelerated in recent weeks as Facebook has faced a new government lawsuit and negative headlines with respect to sharing user data, while Alphabet (Google) has been called to testify before Congress. The much harsher environment has filtered through to forward earnings growth that has plummeted to roughly half the level of the broad market (second panel). Still, amidst the recent market turmoil, the S&P interactive media & services index has been an outperformer. This is somewhat surprising, considering the 40% valuation premium the index maintains relative to the broad market (bottom panel). We think it’s only a matter of time until the valuation catches up with earnings to the downside; stay underweight the S&P interactive media & services index. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. 1 Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com.

Highlights The yen’s sharp rally this week reflected a liquidation of carry trades. EUR/JPY has hit our target of 120, it is time to close our longstanding bearish recommendation on this pair. The downside in AUD/JPY is limited. The Bank of Japan will not stand idly by in front of the deflationary impact of a stronger yen. The coming weeks could witness some dollar softness, but this should prove temporary. Feature The FX market started the year with a bang. The yen rallied massively Thursday morning, during the so-called “witching hour” between the New York close and the Tokyo open. As is now usual, algorithms have been blamed. We agree that poor liquidity and automatized trading accentuated the speed of the move, but ultimately, the strength of the yen is rooted in fundamental reasons. As we have been arguing, the yen should be strong in the current environment, especially against the euro, the Australian dollar and high-yielding EM currencies. When global growth weakens and safe heaven yields fall, the yen benefits. Not only do Japanese domestic savers, who park their funds abroad in hope of higher yields, repatriate there money when growth slows, but also, carry-traders, who fund their purchases of high-yielding assets by selling the yen, buy back the JPY once volatility rises. The above-dynamics have driven the yen’s eye-catching move. The yen has been strong, but the AUD, the EUR, the TRY and the ZAR have also been weak, suggesting that investors who bought the yen also sold these currencies. This was a carry-trade reversal. What should we do with our long-held negative biases on EUR/JPY and AUD/JPY? Last night, EUR/JPY and AUD/JPY moved below 119 and 71, respectively. Our target for these pairs were EUR/JPY 120 and AUD/JPY 72. We are inclined to close these recommendations. As we have repeatedly highlighted, EUR/JPY is a function of global bond yields (Chart I-1). As a firm, BCA sees upward pressure on yields. Currently, the futures market is pricing in potential rate cuts in 2019 and 2020. We think that the U.S. economy is strong enough that the Fed will not cut rates over this timeframe. However, the Fed is likely to pause for one or two quarters, something made even more likely after the fall in the ISM manufacturing this week. Such a pause should create upward pressure on U.S. 10-year inflation breakevens, which currently trade at 1.7%, while also supporting risk asset prices. All these developments would be consistent with higher yields and thus, a stronger EUR/JPY. Chart I-1EUR/JPY Should Now Find Support Regarding AUD/JPY, this pair is now trading in line with the lows experienced in 2016, and at its worst Thursday morning, it traded at levels last recorded in the first half of 2009. We do anticipate continued weakness in the global economy, but not a recession. Hence, at current levels, the downside for AUD/JPY is limited. Beyond the global dynamics, we also need to take into account Japanese dynamics. The JPY may be cheap, but Japan’s core inflation remains well below the Bank of Japan’s objective, and shows little sign of hitting 2% within a reasonable period. The recent strength in the yen only re-enforces the inability of the BoJ to hit its target. In fact, the yen’s strength was met by a large rally in JGBs, with 10-year Japanese yields falling back to zero. We agree with the market’s assessment of the combined impact of a higher yen and slowing global growth: the BoJ will have to fight this deflationary impulse. How, though, is still unclear. The BoJ could cut rates while continuing to target a positive yield curve slope, something we think is likely. Also, Japan still sports a current account surplus as well as the largest positive net international investment position in the word. This means that this country has little to fear from a falling exchange rate. This raises the likelihood that the Ministry of Finance decides to intervene in the FX market in order to push the yen lower. The only constraint here is the U.S. Treasury, which could balk at such a move. Finally, the U.S. dollar has been losing momentum this December, and weaker U.S. economic data is likely to prompt the Fed to openly message that it will pause its hiking campaign for at least one quarter. This should cause a period of softness in the greenback. However, we continue to expect such softness to be temporary. The market anticipates rate cuts from the Fed, but this is not BCA’s baseline scenario. Thus, any pause along the hiking campaign should only have a transitory impact on the dollar, as the U.S. economy is likely to continue to grow above trend, preventing the need for lower rates. Bottom Line: Poor liquidity conditions may have facilitated the yen’s massive move this week, but its true driver was the weakness in global growth, which forced a massive liquidation of carry trades. As EUR/JPY has hit our 120 target, we are removing our long-standing negative bias on this pair. Staying short AUD/JPY at current levels does not make sense either, unless one expects a global recession, which is not our base case. Finally, the strength in the yen is hurting the Japanese economy, which will force the Bank of Japan to ease monetary conditions.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com

Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, January 9th at 10 AM EST, when I will be discussing the economic and financial market outlook for 2019 and answering your questions. Best regards, Peter Berezin, Chief Global Strategist Highlights The lack of major financial and economic imbalances in the U.S., as well as the Fed’s ability to moderate the pace of rate hikes, reduce the risk of a vicious cycle where tighter financial conditions lead to slower economic growth and even tighter financial conditions. The scope for central banks to cut rates is more limited outside the United States. Imbalances are also greater abroad. Nevertheless, the news is not all bleak, with the recent rebound in China’s credit impulse being a case in point. We turned more bullish on risk assets following December’s post-FOMC equity sell-off. A moderately overweight position in global equities over a 12-month horizon is currently justified. While we continue to favor the U.S. over other bourses in dollar terms, our conviction level in this regional bias has decreased. Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. Outside Japan, global government bond yields will also increase in 2019. We are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. We are also taking profits on our March-2019 EEM ETF put for a gain of 104%. Feature Merry Crisis And A Happy New Fear Santa arrived early this year. The plunge in stocks allowed investors to buy some of the world’s premier companies at a mouthwatering 20%-to-30% discount to what they would have paid just a few months earlier. What a gift! Needless to say, most investors would not regard last month’s stock market performance in such a favorable light. But why not? One answer is that investors must mark their portfolios to market. Thus, even if the decline in equity prices raised future returns, it still implied a decline in present net worth. Yet, this cannot be the whole explanation, because if all investors expected stocks to bounce back quickly, they would not have sold in the first place. Clearly, many investors must have come to the conclusion that the stock market would not only go down but stay down. However, this presents a puzzle. The economic environment did not change that much in the weeks leading up to the October sell-off. Growth has slowed more recently (Chart 1), with this morning’s disappointing ISM manufacturing report being the latest example, but this appears to have been mainly a response to the souring market climate rather than the cause of it. Chart 1Tighter Financial Conditions Have Led To Slower Growth Reverse Causality? This raises an intriguing possibility: What if the drop in stock prices and jump in credit spreads that began in late September hurt expectations of economic growth by enough to justify a further discount in risk asset valuations? Such a “Financial Conditions Index (FCI) doom loop” is not just a theoretical construct. The last two U.S. recessions were both the products of burst asset bubbles — first the dotcom bubble and then the housing bubble. Could such a self-fulfilling vicious cycle be erupting again? If so, any rally in stocks or credit should be sold into, just as was the case in both 2001 and 2007. U.S. Fairly Resilient To A Doom Loop Fortunately, there are two reasons to think that such an outcome will not reoccur, at least not in the United States. First, as Box 1 explains, an FCI doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. That does not appear to be the case today. Unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart 2). Cyclical spending – the sum of residential investment, business capex, and expenditures on consumer durable goods – is also far below prior business-cycle peaks as a share of GDP (Chart 3). Chart 2The U.S. Private Sector Is A Net Saver Chart 3U.S. Economy: Cyclical Spending Is Still Restrained Despite recent releveraging in some categories, U.S. household debt has continued to decline in relation to the size of the economy. The ratio of personal debt-to-disposable income is now 34 percentage points below pre-crisis levels (Chart 4). Chart 4Household Leverage Is Below Its Peak U.S. corporate debt has moved in the opposite direction. Nevertheless, while the ratio of U.S. corporate debt-to-GDP has climbed to a record high, it is still quite low by global standards (Chart 5). Perhaps more importantly, corporate debt is generally held by non-leveraged institutions. If corporate defaults were to rise unexpectedly, the losses to lenders would not pose the same systemic risk to the financial sector as mortgage defaults did during the Global Financial Crisis. Chart 5U.S. Corporate Debt Is High, But It Is Higher Elsewhere The Fed’s Reaction Function It is not surprising that the stock market sell-off accelerated in early October following Fed Chairman, and failed golfer, Jay Powell’s comment that interest rates were “far from neutral.” We think that worries that the Fed will tighten too quickly are misplaced. Yes, monetary policy operates with “long and variable lags.” However, financial conditions, which lead growth, can be observed in real time (Chart 6). Chart 6Global Financial Conditions Have Tightened Most of the tightening in financial conditions since late September has been due to falling equity prices. Our baseline scenario envisions a gain of roughly 10% in the S&P 500 in 2019. A rebound in stocks of this magnitude will reverse most of the recent FCI tightening, thereby allowing the Fed to raise rates three times this year. But if equities continue to sag, the Fed will scale back further monetary tightening or even cut rates. The mere possibility of such a policy response reduces the odds of an FCI doom loop. A Mixed Bag Outside The U.S. The economic outlook is murkier outside the United States. Economic and financial imbalances are greater in the EM space and parts of Europe. Non-U.S. central banks also have less scope to respond to adverse shocks, either because of fears that looser monetary policy will spark capital outflows (as is the case in many emerging markets) or because of the presence of the zero-bound constraint on interest rates (as is the case in the euro area and Japan). Nevertheless, the situation is not that bad. EM assets have been fairly resilient over the past few months, at least in comparison to their developed economy counterparts (Chart 7). China’s credit impulse has actually perked up, an indication that while credit growth is falling, it is doing so at a slower pace. Chart 8 shows that the Chinese credit impulse is highly correlated with global industrial commodity prices. We still expect global growth to slow in the first half of 2019, but at this point, much of the slowdown has been discounted in asset markets. With that in mind, we are raising the stop on our short AUD/JPY trade to 10% and instituting a profit target of 15%. Chart 7EM Assets Have Been Outperforming Recently   Chart 8The Increase In China's Credit Impulse Bodes Well For Industrial Commodity Prices The Perils Of Discrete Decision-Making One of the annoyances of being an investment strategist is that you often feel compelled to take discrete views on where the markets are heading. Are you bullish, bearish, or neutral? Actually, it is usually just bullish or bearish because most people regard neutral views as lacking in conviction and insight. This incentive structure is counterproductive. Not only does it cause analysts to turn a blind eye to incoming data that may challenge their thesis, it disregards how professional investors actually operate. Successful investors scale into positions as the market gets cheaper and scale out as it becomes more expensive. Trying to time the bottom (or the top) with exact precision is futile. With that in mind, we are going to tweak the way we make recommendations going forward in order to improve transparency, accountability, and accuracy. Rather than simply stating whether we are bullish, bearish, or neutral, we will assign the main asset classes a subjective score between zero and one hundred, with 0-to-40 being bearish, 40-to-60 being neutral, and 60-to-100 being bullish. We will adjust the score in every publication. To add analytic rigor to this framework, we will also compare our subjective model score with that of our MacroQuant model. Where Things Now Stand We downgraded global equities last June, but moved back to overweight following December’s post-FOMC meeting sell-off, as valuations reached that rather blurry line at which a modest equity overweight was warranted. Our subjective score for global equities currently stands at 65%, above the model’s estimate of 50%. Our moderately bullish view reflects our expectation that global growth will stabilize by mid-year and monetary policy will remain accommodative, even if the Fed raises rates by more than what the markets are currently discounting. Tempering our enthusiasm is the recognition that the business cycle is getting long in the tooth – especially in the U.S. – and that global equity valuations, while far cheaper than they were a few months ago, are still significantly less favorable than they were near past market bottoms (Chart 9). Chart 9Global Equity Valuations Have Improved Regionally, we continue to favor U.S. stocks over other developed markets, and DM over EM more broadly. However, our conviction level on this view is not high, and we are prepared to revise it if it looks like global growth is accelerating, an outcome that would limit any further dollar strength (our subjective dollar score currently stands at 70%, below the model’s estimate of 92%). Reflecting our expectation of decent global equity returns in 2019 and our waning conviction to be underweight EM, we are taking profits on in our March-2019 EEM ETF put for a gain of 104%.  Please note that our view on EM is more optimistic than that of Arthur Budaghyan, BCA’s chief emerging markets strategist, who continues to see considerable downside risks to EM assets. For now, Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. We assign the 10-year yield a score of 30%, which is close to our model estimate of 32%. Accordingly, we are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. Core European bond yields will increase, reflecting diminished excess capacity in the euro area and the end of ECB net asset purchases. U.K. yields should also grind higher, as the odds of a soft Brexit (or no Brexit) improve. Only in Japan will yields remain contained, thanks to the BoJ’s ongoing yield curve control regime. We do not expect spread product to have a banner year, but the current yield pick-up should be sufficient to ensure that risky credit outperforms cash. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Box 1 The Analytics Of Doom Loops When will a tightening in financial conditions stemming from lower equity prices and higher borrowing costs lead to a vicious circle of slower economic growth and even tighter financial conditions? The answer depends on how sensitive economic growth is to financial conditions in relation to how sensitive financial conditions are to growth. Figure 1 shows two equilibrium schedules, one for the economy (EE) and one for asset markets (AA). Both schedules slope downward. The EE schedule is downward-sloping because easier financial conditions boost growth. If growth is too strong given the prevailing level of financial conditions, economic activity will slow (Panel A). The AA schedule is downward-sloping because equity prices tend to fall and credit spreads rise when growth slows. If equity prices are too high and credit spreads are too narrow for a certain level of growth, then financial conditions will tighten (Panel B). Suppose economic growth is not very sensitive to changes in financial conditions, perhaps because imbalances in the economy are limited (Panel C). Then changes in financial conditions will be fleeting: A decline in equity prices or a widening in credit spreads will not hurt growth very much, allowing the stock market and credit market to quickly normalize. In contrast, suppose that economic growth is very sensitive to financial conditions, so much so that the EE schedule is flatter than the AA schedule. In this case, the economy will be vulnerable to self-reinforcing booms and busts (Panel D). In particular, a small random jump from U to UI will send the economy careening towards a doom loop of ever-weaker growth and tighter financial conditions.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2018.  The quant model reduced Spain’s large overweight to a slight overweight, and further downgraded the U.S. allocation. As a result, the model now has assigned overweight allocations to Germany, Switzerland, the Netherlands, Canada and Italy, with underweight allocations to the U.S., Japan, France and U.K.  Australia and Sweden are now in the neutral zone, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI world benchmark by 38 bps in December, with a 48 bps of outperformance from Level 1 model offset by a 21 bps of underperformance from Level 2. Since going live, the overall model has outperformed by 96 bps, with Level 2 outperforming by 120 bps and level 1 outperforming by 57 bps. Table 2Performance (Total Returns In USD %)   Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)     Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.     GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com