Europe

Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems.  Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix

Highlights As long as the global long bond yield stays near 2 percent or below, European equities will end the year at broadly the same level as now… …but they will experience a dip of at least 4-5 percent along the way. All central banks have pivoted to dovish but the Fed has more easing armoury than the ECB. This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. Feature At the start of this year we explained Why 2019 Is A Pivotal Year For Monetary Policy. Today we want to elaborate on that report, and its key observations: Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to tightening emanates from the hyper-sensitivity of financial conditions to rate hikes, rather than from the direct impact on rate-sensitive sectors in the economy. Since October 2017, no stock market rally or sell-off has lasted more than three months or so (Chart Of The Week). These observations are as relevant – or more relevant – now, as they were at the time of our original report.1 Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent. Chart Of The WeekSince October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months A 2 Percent Tightening Is The Post-2008 Limit Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before having to reverse course (Chart I-2 and Chart I-3). Chart I-2A 2 Percent Sequential Tightening Is The Post-2008 Limit Chart I-3A 2 Percent Sequential Tightening Is The Post-2008 Limit     In 2008, Swedish interest rates peaked near 5 percent before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Though admittedly, both Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. However, on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening also of only 1 percent; Korea could manage just 1.25 percent; the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. The Federal Reserve raised interest rates sequentially by 2 percent through December 2016 to December 2018, and guess what – it is now on the cusp of reversing course. The ultimate course will have a huge bearing on investment strategy for European equities, bonds and currencies. The Neutral Real Rate Of Interest Is Zero Many economists and strategists expected the Fed to continue hiking through 2019, but this publication pushed back hard. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. Central to this publication’s resistance was, and is, a high-conviction view that the so-called ‘neutral’ real rate of interest – the real interest rate that is neither accommodative nor restrictive, the real interest rate consistent with an economy maintaining full employment while keeping inflation constant – is zero. The neutral rate of interest is very low. In our Special Report Why The Neutral Rate Of Interest Is Zero we proposed that the neutral rate is global rather than region-specific, that it refers to the bond yield rather than to the policy rate, and that it is extremely low. As it happens, the Fed broadly concurs. With the policy rate, bond yield, and inflation all at around 2 percent, the real policy rate and real bond yield are both near zero. At this level the central bank claims that “the policy stance is now in the Committee’s estimates of neutral… and when you get to that range we have to let the data speak to us.”2  However, the data that is speaking most loudly is not necessarily the economic data, it is the financial market data. Jay Powell has said that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” We think it has (Chart I-4). Comparing Today’s Rich Valuations With 2007 In the aftermath of the dot com bubble burst in 2000, policy interest rates collapsed to very low levels but, crucially, long bond yields did not. This contrasts with the aftermath of the Global Financial Crisis in 2008, during which both policy interest rates and bond yields have plunged to all-time lows (Charts I-5 - I-7). Funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. Chart I-5In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did Chart I-6In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did   Chart I-7In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did The difference between the post-2000 and post-2008 policy responses can be summarized in two letters: QE. For all its apparent complexity, QE is actually a very simple monetary policy tool. It is just a mechanism for signalling that the policy interest rate will remain low for an extended period. Thereby, QE pulls down the long-term interest rate, which is to say the long bond yield. The double-digit rally over the past six months is technically extended. But as we have consistently pointed out on these pages, funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. We refer readers to our other reports for the details, but in a nutshell the risk of owning bonds converges to the risk of owning equities and other so-called ‘risk-assets’. The upshot of this risk convergence is that investors price these risk-assets to deliver the same ultra-low nominal return as bonds, meaning that the valuation of the risk-assets soars.3   Chart I-8Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent All of which brings us to the crucial point. The post-2000 extreme policy easing distorted the real economy. It engineered a credit boom. So the fragility to the subsequent policy tightening emanated from the real economy, and particularly the most rate-sensitive sectors in the economy such as mortgage lending and housing. In contrast, the post-2008 extreme policy easing – driven by QE – has distorted the valuation of risk-assets. Moreover, the value of global risk-assets, at $400 trillion dwarfs the $80 trillion global economy by five to one. So the current fragility to policy tightening does not emanate from the real economy, it emanates from the hyper-sensitivity of financial conditions to higher bond yields (Chart 8). Some European Investment Implications The integration of global capital markets means that the valuation anchor for European – and all regional – stock markets now comes from the global long bond yield, which we define as the simple average of the 10-year yields in the euro area, U.S., and China. Through the past five years, the inability of the global long bond yield to remain above 2.5 percent confirms the hyper-sensitivity of financial conditions to higher interest rates. And it suggests that the ‘neutral’ rate on this measure is around 2 percent. The good news is that this measure now stands slightly below neutral at 1.9 percent. The euro has a sound structural underpinning versus the dollar. At around this level of the global long bond yield, the rich valuation of European equities has some support. That said, the double-digit rally over the past six months is technically extended, as most of the things that could go right did go right – central banks pivoted to dovish, euro area growth rebounded, and, until recently, geopolitical risks were easing. Hence, as long as the global long bond yield stays near 2 percent or below, we expect European equities to end the year at broadly the same level as now, though our technical signals do strongly suggest a dip of at least 4-5 percent along the way (Chart I-9). Chart I-9The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended Chart I-10The Fed Has More Easing Armoury Than The ECB As regards bonds and currencies, all central banks have pivoted to dovish but the Fed has more easing armoury than the ECB (Chart I-10). This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. However, this structural underpinning also applies to the yen, and until we get some clarity on Brexit we prefer the yen over the euro.   Fractal Trading System* In line with the main body of this report and Chart 9, we see evidence that the double-digit rally in stock markets over the past six months is technically extended. Accordingly, this week’s recommended trade is to short the MSCI All-Country World index, setting the profit target at 4 percent with a symmetrical stop-loss. This leaves us with four 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. *      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 Footnotes 1      Please see the European Investment Strategy Weekly Report ‘Why 2019 Is A Pivotal Year For Monetary Policy’ February 7, 2019 available at eis.bcaresearch.com. 2      Please see the European Investment Strategy Special Report ‘Why The Neutral Rate Of Interest Is Zero’ June 6, 2019 available at eis.bcaresearch.com. 3      Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.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      

Highlights 10-year real Spanish and Portuguese bond yields have already fallen below the neutral rate of interest for the entire euro zone. This suggests monetary conditions could now be favorable for all euro zone countries. Should external demand pick up, this will also help lift the equilibrium rate for the monetary union, which will be a tailwind for the EUR/USD. Falling U.S. rate expectations relative to policy action have historically been bearish for the dollar, with a lag of about six to 12 months. A risk to this view is further deterioration in the U.S.-China trade war, or a rollover in Chinese stimulus. Remain long EUR/CHF, with a tight stop at 1.11. Our bias is that the Swiss National Bank will continue to use the currency as a weapon to defend the economy. Feature The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others such as Spain and Italy. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. Over the years, the impasse has been resolved from time to time through a combination of internal devaluation, currency depreciation and a successively accommodative European Central Bank. This has helped prevent a collapse of the monetary union, but in the process generated tremendous volatility in the currency. Since the onset of the Great Recession, the EUR/USD has seen five boom/bust cycles of about 20% to 25%. For both domestic policymakers and global investors alike, this has been an untenable headache. The silver lining is that the ECB may now have finally lowered domestic interest rates and eased policy to the point where they are accommodative for almost all euro zone countries: 10-year government bond yields in France, Spain and even Portugal now sit at 11bps, 54bps and 65bps respectively, much below the neutral rate. This is severely easing financial conditions in the entire euro zone, with huge implications for European assets in general and the euro in particular. In short, the EUR/USD may be very close to a floor (Chart I-1). Chart I-1How Much Lower For Relative R-Star*? Structural Reforms Have Progressed The neutral rate of interest is simply the market price at which both the supply of savings and the demand for them clear. In academic parlance, this means the interest rate at which the economy is at full employment, but inflationary pressures are relatively contained. At this critical interest rate level, the economy tends to be in balance. The difficulty arises because most indicators of either full employment or inflation tend to be lagging. As such, steering interest rates toward the neutral level becomes a very difficult task for any one country and/or central bank to achieve in real time. For the euro zone as a whole, where member countries can have vastly diverging economic outcomes at any point in time, the task becomes even more arduous.   This is why since the introduction of the euro, most of the economic imbalances from the region have stemmed from the standard contradiction of a common currency regime. For most of the early 2000s, Spanish and Irish long-term rates were too low relative to the potential of their respective economies, and the reverse was true for Germany. As a result, Spanish real estate took off in what culminated to be one of the biggest booms in recent history, while it stagnated in Germany. And after the Great Recession, the reverse was true: rates became too low for the most productive nation, Germany, and too high for Ireland and Spain (Chart I-2). In a normal adjustment process, the exchange rate always tends to play a key role. In a common-currency regime, there is not such a possibility.  In a normal adjustment process, the exchange rate always tends to play a key role, since countries with lower productivity growth require a lower neutral rate, and as such see currency depreciation. This tends to ease financial conditions, alleviating the need for an internal adjustment process. However, in a common-currency regime, there is not such a possibility. The result is a painful process of internal devaluation, as was very vivid in the European peripheral countries from 2009-2012 (Chart I-3). Chart I-2The Common-Currency Dilemma Chart I-3Internal Devaluation In The South... The good news is that for the euro zone, it forced businesses to restructure and jumpstarted the process of structural reform. In the early 2000s, the German economy had to restructure in order to improve its competitiveness. As a result, unit labor costs began to lag in 2001. Over the same period, the German government began to reform the labor market. The Hartz IV labor market reforms implemented minimized safety nets for the unemployed, encouraging them to accept market-determined wages. This dramatically increased the flexibility of the labor market. The same script has been replayed over the last decade with the European periphery. Labor market reforms in Mediterranean Europe have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract by almost 10%. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart I-4). Italy remains saddled with a rigid and less productive workforce, but overall adjustments have still come a long way to closing a key fissure plaguing the common currency area. At the same time, other factors also suggest the neutral rate for individual countries should also have converged higher to that of Germany. Peripheral sovereign borrowing costs have plummeted from their prohibitive 2012 levels. As a result, interest payments as a share of GDP have become more manageable. Most southern European countries now run primary surpluses, reducing the need for external funding. Fortunately, the improvement in structural budget balances has diminished the need for any additional austerity measures, meaning government spending should no longer be a net drag on GDP growth. Increased integration continues to sustain a steady stream of cheap migrant workers to Germany.  On the labor market front, the unemployment rate in Germany remains well below that in other regions, but increased integration continues to sustain a steady stream of cheap migrant workers to Germany. Over the last decade, there has been a surge of migrant workers into Germany from countries such as Portugal or Spain (Chart I-5). This will help redistribute aggregate demand within the system. Chart I-4...Has Realigned Competitiveness Chart I-5The Unemployment Gap Is Closing The bottom line is that the various forces that may have been keeping the neutral rate of interest artificially low in the euro area are ebbing. The proverbial saying is that a chain is only as strong as its weakest link. This means that if these forces pressuring equilibrium rates in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire euro zone. Over a cyclical horizon, this should be bullish for the euro (previously referenced Chart I-1). Manufacturing Recession May Soon End With the rising specter of a full-blown trade war and a global manufacturing recession, it is possible that euro zone policy settings have become even more appropriate for Germany than the rest of Europe. For example, the latest PMI releases suggest that Germany is the weakest link in the euro zone on the manufacturing front (Chart I-6). The implication is that if the ECB’s monetary settings are now being calibrated for Germany, they may also now be appropriate for all euro zone countries. For example, since 2015, peripheral country exports have increased to 28% of GDP, from a low of 16%, despite strength in the trade-weighted euro. This contrasts favorably with Germany, where the export share of German GDP has essentially been flat over this period (Chart I-7). In fact, it is entirely possible that the German economy may have already 'maxed out' its export market share gains, given its externally driven growth model over the last decade. If so, further currency weakness can only lead to inflation and wage pressures in Germany, redistributing demand from exports to the domestic sector, while benefitting the periphery. Chart I-6Germany Is Once Again The Sickman Chart I-7GIPS Are Gaining Export Share Over the past few years, corporate profits as a share of GDP in both Portugal and Spain have overtaken German levels. And with the output gap is still open in these countries, it will take a while before the unemployment rate moves below NAIRU and begins to generate wage pressures. This will allow companies to continue reaping a labor dividend while gaining export market share. It is not easy to tell if and when the trade war will end sans escalation, but there remain a number of green shoots in the European economy: While the German PMI is currently one of the weakest in the euro zone, forward-looking indicators suggest we are on the cusp of a V-shaped bottom over the next few months or so (Chart I-8). A rising Chinese credit impulse is usually bullish for European exports, and this time should be no different (Chart I-9). This also follows improvement in the European credit impulse. Most European growth indicators relative to the U.S. hit a nadir at the beginning of this year, and have been steadily improving since.1 Chart I-8German Manufacturing Could Soon Bottom Chart I-9A Pick Up In Global Demand Will Help The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when policy settings have become appropriate for the weakest link. If, in fact, European growth and inflation improve relative to the U.S., this will give investors an opportunity to reassess interest rate expectations for the euro area versus the U.S. Implications For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts began aggressively revising up their earnings estimates for euro zone equities verus the U.S. earlier this year. If they are right, this tends to firmly lead the euro by about nine to 12 months, suggesting we are due for a pop in the coming quarters (Chart I-10).  Chart I-10Rising Earnings Revisions Are Bullish For The Euro The euro’s bounce after the ECB’s latest meeting suggests its dovish shift is paradoxically bullish for the common currency. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. This in combination with easier fiscal policy should boost aggregate demand and lift the neutral rate of interest in the euro zone. Dollar weakness could be the catalyst that triggers a EUR/USD rally. Markets are usually wrong about Federal Reserve interest rate expectations, and this time is likely to be no different. However, the current divergence between market expectations and policy action is the widest since the Great Recession. Falling rate expectations relative to policy action have historically been bearish for the dollar with a lag of about nine to 12 months (Chart I-11). The basic balance in the euro area is on the verge of hitting fresh highs. Finally, positioning, valuation and balance-of-payments dynamics remain favorable for the euro (Chart I-12). The basic balance in the euro area is on the verge of hitting fresh highs on the back of improvement in FDI flows. With a large number of short positions on the euro, this could trigger a significant short-covering rally. Chart I-11The Dollar Might ##br##Soon Peak Chart I-12A Favorable Balance Of Payments ##br##Backdrop For The Euro   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “A Contrarian Bet On The Euro,” dated March 1, 2019, available at fes.bcaresearch.com.  Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly negative, but a few one-time factors were at play: On the labor market front, nonfarm payrolls fell to 75 thousand in May, but this was dragged down by flooding in the Midwest. Average hourly earnings grew by 3.1% year-on-year and the unemployment rate was stable at 3.6%. Headline and core consumer price inflation came in slightly lower at 1.8% and 2% year-on-year, but remain on target. Export prices fell by 0.7% year-on-year in May, and import prices contracted by 1.5% year-on-year, giving the greenback a terms-of-trade boost. On a positive note, the NFIB Small Business Optimism survey rose to a 5-month high of 105 in May. On another positive note, mortgage applications jumped by 26.8% this week. DXY index rose by 0.3% this week. Our bias is that the dollar is in the final innings of its rally, amid narrowing interest rate differentials, portfolio outflows, and easing liquidity strains.  Should global growth benefit from the dovish pivot by central banks, this could be the catalyst for dollar downside. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 There has been tepid data out of the euro zone this week: Sentix investor confidence fell to -3.3 in June. Industrial production contracted by 0.4% year-on-year in April. This is an improvement compared with the last reading of -0.7% and the consensus of -0.5%. EUR/USD fell by 0.3% this week. The front section this week is dedicated to the euro, since it has begun to tick many of the boxes for a counter-trend rally. The euro is trading below its fair value, easy financial conditions within the euro area will help, and Chinese stimulus could boost European exports, lifting the growth potential for the entire union. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The leading economic index fell to 95.5 in April, while the coincident index increased to 101.9. Annualized GDP growth was 2.2% year-on-year in Q1. Quarter-on-quarter growth also improved to 0.6%. The current account balance came in at 1.7 trillion yen in April. This was lower than the previous 2.9 trillion figure, but an improvement over consensus. Machine tool orders contracted by 27.3% year-on-year in May, while machinery orders increased by 2.5% year-on-year in April. It is worth noting that the pace of deceleration in machine tool orders is ebbing. USD/JPY has been flat this week. We continue to recommend the yen as an insurance against market turbulence. Even though the yen might weaken on the crosses in a scenario where global growth picks up later this year, it still has upside potential against the U.S. dollar. Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: Halifax house prices increased by 5.2% year-on-year in May. Industrial production contracted by 1% year-on-year in April. Manufacturing production also contracted by 0.8% year-on-year. The trade deficit narrowed to 2.74 billion pounds in April. The ILO unemployment rate was unchanged at 3.8% in April, while average earnings growth keeps holding firm, though it fell slightly to 3.1%. GBP/USD fell by 0.4% this week, now oscillating around 1.268. We will respect the stop loss for our long GBP/USD position if triggered at 1.25. While cheap valuation and favorable fundamentals support the pound on a cyclical basis, the implied volatility remains elevated amidst political uncertainties. The official kickoff for a new Conservative party leader is poised to ratchet up “hard Brexit” rhetoric, which will be negative for the pound. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have shown a steady labor market: Consumer inflation expectations were unchanged at 3.3% in June. On the labor market front, the participation rate increased to 66% in May; unemployment rate was stable at 5.2%; 42.3 thousand new jobs were created in May but the mix was unfavorable, with a combination of 2.4 thousand full-time jobs and 39.8 thousand part-time jobs. AUD/USD fell by 1.3% this week. Clearly, the Australian jobs report was interpreted negatively by the market, given the boost from temporary election hiring. As such, markets are continually pricing in further rate cuts from the RBA, a negative for interest rate differentials between Australia and the U.S. Over the longer term, easier financial conditions could help to lift the economy, and stabilize the housing sector by reducing the interest payment burdens.  Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Manufacturing sales were unchanged at 2% in Q1. Electronic card retail sales growth grew by 3.2% year-on-year in May, higher than the consensus of 1.6%. Immigration remains a tailwind for domestic demand, but is slowly fading. NZD/USD fell by 1.4% this week. We introduced a long SEK/NZD trade last Friday, which is now 0.3% in the money. We believe that the Swedish krona will benefit more than the New Zealand dollar once global growth picks up.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The labor market remains robust with 27.7 thousand new jobs created in May. This pushed the unemployment rate to a low of 5.4%. The participation rate fell slightly to 65.7% but average hourly wages increased by 2.6% year-on-year. The mix was also positive, with all of the jobs generated as full-time employment. Housing starts came in at 202.3 thousand in May, while building permits increased by 14.7% month-on-month in April. USD/CAD initially fell by 1% on the labor market data last Friday, then recovered gradually, returning flat this week. While the labor market remains strong and the housing sector is showing signs of a recovery, the recent weakness in energy prices has been a headwind for the loonie. Moreover, a rate cut by BoC has become increasingly likely following the dovish shift by the Fed. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There has been little data out of Switzerland this week: The unemployment rate was unchanged at 2.4% in May. Foreign currency reserves fell slightly to 760 billion CHF in May. Producer and import prices contracted by 0.8% year-on-year in May. USD/CHF appreciated by 0.4% this week. The Swiss National Bank maintained  interest rates at -0.75% this week. The policy remains expansionary, in order to stabilize price developments and support economic activity. As a technicality, the SNB will also stop targeting Libor rates in favor of SARON (Swiss Average Rate Overnight). More importantly for the franc, the SNB stated that they will “remain active in the foreign exchange market as necessary, while taking the overall currency situation into consideration.” This suggest the SNB will weaponize the franc against deflationary pressures. Remain long EUR/CHF. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have softened: Manufacturing output increased by 2.2% month-on-month in April. Headline and core inflation both fell to 2.5% and 2.3% year-on-year in May. This has nudged the core measure below the central bank’s target. Producer price inflation fell to 0.4% year-on-year in May. USD/NOK rose by 0.6% this week. The recent plunge in oil prices caused by the U.S. inventory buildup has been a headwind for the Norwegian krone. However, we expect U.S. shale-oil production to eventually slow as E&P companies exercise greater capital discipline as marginal profit decreases. Moreover, irrespective of the oil price direction, we expect the Norwegian krone to outperform other petro-currencies, such as the Canadian dollar. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: PES unemployment rate fell further to 3.4% in May. Household consumption increased by 0.2% month-on-month in April, but was unchanged on a year-on-year basis. USD/SEK appreciated by 0.9% this week. We favor the krona due to its cheap valuation, and its higher β to global growth (the potential to benefit more from a global economy recovery). We initiated the long SEK/NZD position last week, based on improving relative fundamentals between Sweden and New Zealand. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The European barometer that best gauges global growth is euro area growth excluding inventory adjustments. Euro area growth excluding inventory adjustments is now running at a blistering 4.2 percent nominal pace – close to its 10-year upper bound – and is unlikely to accelerate much further. All the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer will show weaker readings in the second half of the year. We present the correct investment strategy for this environment within the report. Feature Chart of the WeekGrowth Isn’t Going To Get Much Better Europe is an excellent barometer of the world economy. Not only is Europe a big chunk of the global economy in its own right, Europe also has a very open economy with a huge external sector. Gross exports amount to almost a half of GDP in the euro area, compared to little more than a tenth in the United States (Chart I-2). But here’s the key point: the European barometer that best gauges global growth is not euro area growth per se; it is euro area growth excluding inventory adjustments (Chart of the Week and Chart I-3). Chart I-2Europe Has A Very Open Economy Chart I-3Euro Area Growth Ex Inventory Adjustments Has Rebounded Sharply If euro area firms were building inventories, it would clearly boost economic output; and vice versa. However, this inventory building would not represent genuine end demand from abroad. It follows that we must strip out inventory adjustments to yield a truer gauge of external demand.1 The Reading From Our European Barometer What does euro area growth excluding inventory adjustments show? The long-term analysis confirms that global activity suffered its sharpest setbacks this millennium in 2002, 2008, 2012, and again briefly last year. But in the first quarter of this year, euro area real growth excluding inventory adjustments bounced back to a very robust 2.5 percent clip or, in nominal terms, a blistering 4.2 percent clip.2 Indeed, in nominal terms, our barometer was close to its strongest reading since 2010! These impressive numbers leave us with not a shred of doubt: after a sharp setback, global growth commenced a strong rebound at the end of last year. Global growth commenced a strong rebound at the end of last year. For those still in doubt, further compelling evidence comes from the very clear recent outperformance of the economically sensitive global sectors: industrials and financials. Through the past decade, the relative performance of these global cyclicals has closely tracked our European barometer – albeit a brief decoupling did occur in 2012 after Draghi’s “whatever it takes” speech gave all financial assets a big shot in the arm (Chart I-4). Chart I-4Global Cyclicals Are Tracking Our Growth Barometer One problem is that our barometer gives a reading just once a quarter and these readings come out after a long delay. From the mid-point of the quarter to which the GDP data refers to their release date around one month after the quarter end, there is a two and a half month delay. Begging the question, is there a more frequent and timely current activity indicator (CAI) for the euro area? The answer is yes. We have found that the ZEW economic sentiment indicator (not to be confused with the current situation indicator) does the job well in real-time (Chart I-5 and Chart I-6). Chart I-5The ZEW Economic Sentiment Indicator... Chart I-6...Is A Good Current Activity Indicator   How Should Investors Use Our Barometer? However, investors face an even more fundamental problem. The equity market is itself a real-time current activity indicator. To be more precise, the best current activity is not the equity market taken as a whole – because the aggregate equity market can move as a result of drivers other than current economic activity, most notably central bank policy. Rather, as we have just shown, the very best current activity indicator is the performance of economically sensitive sectors – such as industrials and financials – relative to the total market (Chart I-7 and Chart I-8). Chart I-7The Best Current Activity Indicator... Chart I-8...Is The Relative Performance Of Global Cyclicals This means that even if we could measure GDP growth excluding inventory adjustments in real time, it would not help investors. After all, it would be ludicrous to expect one current activity indicator consistently to lead another current activity indicator! What we really need is a future activity indicator (FAI). If we could reliably predict where our barometer’s reading would be three or six months from now we could also reliably allocate our investments ‘ahead of the move’. Still, sometimes the current reading does inform us about the future. If a barometer already reads ‘very dry’ then we know that the weather is not going to get any better in the next few months! To be clear, euro area nominal growth excluding inventories, running at a blistering 4.2 percent pace, is near a 10-year high not just on a quarter-on-quarter basis but also on a six month on six month basis. The chances that it moves significantly higher are close to nil.   We are at the tail-end of a global growth up-oscillation. We should also look at the short-term impulses that drive growth. Crucially, these emanate from the short-term changes – and not the levels – of bond yields, the oil price (inverted), and bank credit flows. These impulses are now losing momentum (Chart I-9). Chart I-9Short-Term Impulses Are Losing Momentum The Correct Investment Strategy   To sum up, all the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer – euro area growth excluding inventory adjustments – is highly unlikely to accelerate much further from its blistering 4.2 percent nominal clip. Much more likely, it will show weaker readings in the second half of the year. The yen is still an excellent defensive currency. Nevertheless, in the near term, asset allocation is a tough call. This is because, very unusually, all asset classes have performed well in unison, making it hard to rotate into one that offers value (Chart I-10). Hence, from a tactical perspective, we are shorting a 30:60:10 portfolio of equities, long-dated bonds, and crude oil. So far, the position is slightly down but we recommend holding it until it either achieves a 3 percent profit or it hits a 3 percent stop-loss. Chart I-10All Asset-Classes Have Performed Well In Unison For equities versus bonds, our long DAX versus the 30-year bund is now broadly flat since inception in January. But we will hold it for a while longer until we see clearer signs that global growth has flipped into a down-oscillation.   Within bonds, our underweight German 10-year bunds versus U.S 10-year T-bonds is still appropriate given the closer proximity of the bund yield, at -0.2 percent, to the mathematical lower bound. Moreover, this relative position has been working well recently.  Within equities, overweight European equities versus China and the U.S. has also been working well. However, we will be looking for opportunities to switch to underweight Europe versus the less economically sensitive U.S. equity market within the next couple of months. Finally, our stance to the euro – long versus the dollar, short versus the yen – has also been working well. The stance remains appropriate as the yen is still an excellent defensive currency, with the big additional advantage of possessing minimal political risk. Fractal Trading System* Given the synchronized rally of all asset classes this year, the financial services sector has strongly outperformed the market. But according to its 130-day fractal dimension, this strong outperformance is approaching technical exhaustion. Accordingly, this week’s trade recommendation is to short the financial services sector versus the market. The profit target is 2 percent with a symmetrical stop-loss. (One way of executing this is to short the IYG ETF versus the MSCI All Country World Index). In other trades, we are pleased to report that short NZX 50 versus FTSE100 achieved its 2 percent profit target and is now closed, leaving three 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-11 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 Footnotes 1 To be precise, it is the change in the change in inventories that contributes to GDP growth. For example, if the change in inventories added 0.5 percent to GDP this quarter, but 1 percent last quarter, then it will have subtracted 0.5% from growth this quarter. 2 Quarter-on-quarter growth at annualised rates. 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