Germany

Highlights Low Bond Volatility: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan, are likely to stay range bound. USTs vs Bunds/JGBs: Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Feature Bond Yields Are In Winter Hibernation Developed market (DM) government bonds, never the most exciting of asset classes to begin with, have become boring of late. While benchmark 10-year yields since the end of January have moved in line with our recommended country allocations - lower in Germany (-7bps), Japan (-3bps), the U.K. (-5bps) and Australia (-11bps) where we are overweight, higher in the U.S. (+5bps), Canada (+2bps) and Italy (+19bps) where we are underweight – government bonds have settled into trading ranges and lack direction. The proximate trigger for the muted yield volatility was the Federal Reserve shifting to a neutral stance on U.S. monetary policy in January. Investors have priced out any possibility of a Fed rate hike over the next year, and now even discount a modest rate cut, according to the U.S. Overnight Index Swap (OIS) curve. Yet while most of the attention for bond investors have been focused on the U.S., there are developments in other major economies that are also depressing yields – namely, weakening economic momentum and sluggish inflation. In particular, the downturn has shown no signs of stabilizing in the eurozone and Japan, with the latest readings on manufacturing PMIs now below the 50 line, signaling a contraction (Chart of the Week). The latest data in both regions still shows that core inflation is nowhere near the inflation targets of the European Central Bank (ECB) and Bank of Japan (BoJ). The story is much different in the U.S, with the manufacturing PMI still well above 50 and core inflation hovering close to the Fed’s 2% inflation target. Yet Treasury yield volatility has collapsed, with the MOVE index of Treasury options prices now back to the lows of this cycle. Chart Of The WeekAre Treasuries Leading Or Following? For the time being, non-U.S. factors are driving the direction of global bond yields. We think that will change later this year, as steady U.S. growth and surprisingly firm U.S. inflation readings will prompt the Fed to begin hiking rates again. Yet until there are signs that non-U.S. growth is stabilizing, the low yields in Europe and Japan will act as an anchor on U.S. Treasury yields, particularly given how wide U.S./non-U.S. yield differentials already reflect faster growth and inflation in the U.S. Decomposing Treasury-Bund & Treasury-JGB Spreads When looking at the pricing of the “Big 3” DM government bond markets – the U.S., Germany and Japan – there are some major differences but also some similarities as well. Even with the benchmark 10-year U.S. Treasury sitting at 2.68% compared to a mere 0.11% and -0.03% on the 10-year German Bund and 10-year Japanese government bond (JGB), respectively. Simply looking at the breakdown of those nominal 10-year yields into the real and inflation expectations components, there is not much of a comparison (Chart 2). The real 10-year Treasury yield is in positive territory at 0.6%, compared to -1.4% and +0.2% for JGBs and German bunds, respectively. Inflation expectations, measured by 10-year CPI swap rates, are 2.1% in the U.S., 1.5% in Germany and 0.2% in Japan. Thus, the current wide 10-year Treasury-Bund spread (just under +260ps) can be broken down into a real yield spread of +200bps and an inflation expectations gap of +60bps. In the case of the 10-year Treasury-JGB spread (just under +270bps), that breaks down into a real yield differential of +80bps and an inflation gap of +190bps. Chart 2Big Differentials Here... So while the Treasury-Bund and Treasury-JGB spreads are of similar magnitude, the valuation components driving the spread are much different. The former is more of a real yield gap, while the latter is more of an inflation expectations gap. That is no surprise given the BoJ’s Yield Curve Control policy that maintains a ceiling on the 10-year JGB yield of between 0.1% and 0.2%, limiting how much real yields can move (there are no BoJ restrictions on the level of CPI swap rates). Yet the U.S.-Japan inflation expectations gap is not too far off the spread between realized headline and core inflation measures in both countries - both are 1.4 percentage points higher in the U.S. as of January. Looking at other valuation metrics, the cross-county differentials are less pronounced (Chart 3). Chart 3...But Less So For Other Yield Measures Yield curves are quite flat, with the 2-year/10-year slope a mere +16bps in the U.S., +14bps in Japan and only +66bps in Germany. Our estimates of the term premia on 10-year government debt are negative for all three markets, most notably in the countries that have seen quantitative easing in recent years (-10bps in the U.S., -90bps in Germany and -60bps in Japan). Perhaps most importantly, our preferred measure of the market pricing of the real terminal policy rate – the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is +0.2% in the U.S., -0.5% in Germany and 0.0% in Japan. That means the market is pricing in only a +70bp differential, in real terms, between the neutral policy rates of the Fed and ECB. That gap is only +20bps between market pricing of the neutral real rates for the Fed and BoJ. That narrower gap between the market-implied pricing of the real neutral rate is consistent with the theoretical macroeconomic drivers of real rate differentials, like growth rates of potential GDP and labor productivity. According to OECD estimates, potential GDP growth is 1.8% in the U.S., 1.5% in the overall euro area and 1.2% in Japan (Chart 4). This implies a long-run real yield gap between the U.S. and Germany of +60bps and the U.S. and Japan of +30bps – very close to the market pricing for the real terminal rate differentials.1 When looking at the 5-year annualized growth rates of labor productivity data from the OECD, there is no difference between the three regions with all growing at a mere 0.5% (suggesting that either a faster growth rate of the labor input, or greater productivity of capital, accounts for the higher potential growth rate in the U.S.). Chart 4No Major Differences In Long-Run Real Growth With the cross-country yield spreads now effectively priced for the long-run real growth differentials between the U.S. and Europe/Japan, this will limit the ability for nominal Treasury-Bund and Treasury-JGB spreads to widen much further. Right now, U.S. inflation expectations are rising faster than those of Europe and Japan, in response to the Fed’s more dovish stance. Yet if those expectations continue to rise, likely in the context of stickier realized U.S. inflation alongside solid U.S. growth, then the Fed will return to a hawkish bias. That ultimately means higher U.S. real yields and, most likely, some pullback in U.S. inflation expectations since the markets would begin to price in the implications of the Fed moving to a restrictive policy stance (including a stronger U.S. dollar that will help dampen U.S. inflation, at the margin). So that means inflation differentials between the U.S. and Germany/Japan can move wider now but will narrow later; and vice versa for real yield differentials (narrower now and wider later). The main investment implication: nominal UST-Bund and UST-JGB spreads are unlikely to move much wider, likely for the remainder of this business cycle/Fed tightening cycle. The main takeaway is that bond yields in core Europe and Japan are effectively anchoring global yields, in general, and U.S. yields, in particular. Treasury yields will not be able to break out of the current narrow trading ranges until there are signs that growth has stabilized in Europe and Japan. Reduced global trade tensions and faster Chinese growth (and import demand) are necessary conditions to reflate the export-heavy economies of Europe and Japan. Yet even if that scenario does unfold in the months ahead (which is BCA’s base case scenario), there is still a case to prefer Bunds and JGBs over U.S. Treasuries on a currency-hedged basis in U.S. dollars. Given the wide short-term interest rate differentials between the U.S. and Europe/Japan, those near-zero 10-year Bund and JGB yields, after hedging into U.S. dollars, are actually higher than 10-year Treasury yields, which benefits the relative hedged performance of the low-yielders versus the U.S. (Chart 5) Chart 5Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Thus, we continue to recommend an overweight stance on core Europe and Japan, versus an underweight tilt on the U.S., in global U.S. dollar-hedged government bond portfolios. Bottom Line: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan are likely to stay range bound. Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com    Footnotes 1      We are using the full euro area data for these economic comparisons, even though we are discussing U.S.-German yield differentials in this report. We think this is reasonable given the status of German government bonds as the benchmark for the euro area, and with the ECB setting its monetary policy for the overall euro area. The differences between the data for Germany and the overall euro area are modest, with German potential GDP and 5-year productivity growth both only 0.3 percentage points higher. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Fed Policy: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to justify a continuation of the Fed’s dovish stance. With the market now discounting no change in Fed policy rates over the next year, the risks for U.S. Treasury yields are now tilted to the upside. ECB Policy: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year. U.S. & European Duration: Keep global duration exposure below benchmark, with a more defensive stance on U.S. Treasuries over German Bunds given that the Treasury-Bund spread has overshot to the downside. Feature “In fact, our policy works through changing financial conditions, so it’s sort of the essence of what we do” – Federal Reserve Chairman Jerome Powell Have central bankers now turned TOO dovish? That is a question that will be answered in the coming weeks and months after the Federal Reserve and European Central Bank (ECB) signaled a more cautious outlook on growth and inflation. Both central banks cited common causes for the increased caution, such as financial market instability related to geopolitical uncertainty (U.S.-China trade tensions, Brexit, the U.S. government shutdown). Importantly, neither the Fed nor ECB expressed conviction that monetary policy settings were now too restrictive. The sharp selloff in global stock and credit markets at the end of 2018 did tighten financial conditions which, in and of itself, should result in slower growth on either side of the Atlantic in the first half of 2019 (Chart of the Week). Yet we do not expect a move to a below-trend pace of growth that would trigger rising unemployment and weaker inflation pressures. Chart of the WeekFed Too Dovish, ECB Not Dovish Enough The shift to a more dovish posture by the Fed and ECB has already induced some easing of financial conditions to help support growth in the U.S. and Europe until the uncertainties over geopolitics and the Chinese economy are resolved. This appears to be providing more stimulus to economies that may not necessarily need it. That is a risk that policymakers have decided to take to protect against the downside tail risks to economic growth and confidence from global uncertainty. In terms of fixed income markets, more dovish policymakers have created a pro-risk backdrop that will support the outperformance of corporate bonds versus government debt over the next 3-6 months. Without a deeper slowdown of global growth beyond what is currently expected, however, this will only be a temporary respite as central banks revert back to fighting inflation pressures instead of calming financial markets. The result will be a return to monetary tightening and higher bond yields, although that is a far more likely scenario in the U.S. than in Europe over the next 6-12 months given the relative signals from our Central Bank Monitors (bottom panel). Fed Outlook – A Temporary Dovish Turn, Nothing More The quote at the beginning of this report was taken from Fed Chair Powell’s press conference after last week’s FOMC meeting, in response to a question on how the Fed thinks about financial conditions. We can think of no cleaner way to explain the Fed’s understanding of how its monetary policy actions get transmitted to the real economy. By inducing changes in financial asset values (equity prices, corporate bond yields, the value of the U.S. dollar) through adjustments in the fed funds rate – and perceptions about its forward path – the Fed is able to impact the cost of financing across much of the U.S. economy. The goal is either to slow or stimulate growth, as needed, to allow the Fed to reach its dual mandate of maximizing employment while keeping inflation stable. Viewed from this perspective, the Fed’s “dovish” turn last week was a necessary step to not only stabilize financial markets, but to induce a pro-growth rally in risk assets that had sold off too aggressively. On that front, the Fed can say “Mission Accomplished”. Year-to-date, the S&P 500 is up 8% while U.S. investment grade and high-yield corporate bond spreads have fallen by 26bps and 110bps, respectively. The U.S. dollar is also down 1.6% since the start of the year, providing further stimulus to the U.S. economy. U.S. Treasury yields, which had fallen thanks to lower real and inflation components, have also helped ease financial conditions. Real yields have declined as the market has moved to price out all Fed rate hikes for 2019 in response to some signs of cooling U.S. growth (i.e. housing) and the big fall in asset prices. At the same time, inflation expectations have drifted lower as markets now expect the plunge in oil prices seen in 2018 to filter though more broadly into lower realized inflation (Chart 2). Chart 2Too Much Pessimism In UST Yields The ability for yields to decline further is now limited, however, with U.S. economic growth likely to continue at an above-trend pace in the next few quarters, based on the readings from reliable indicators. The ISM Manufacturing index rebounded to 56.6 in January, still well above the 50 level indicating an expanding U.S. economy, even after the decline that began last September. Within the sub-components of the index, the New Orders series also rose last month by 6.9 points, suggesting that the bounce in the overall ISM series could persist. The 10yr UST yield broadly tracks the ISM Manufacturing index (Chart 3), with the post-crisis relationship indicating that the bond yield will have difficulty falling below 2.5% if the ISM remains above 55. Chart 3U.S. Treasuries Vulnerable To Better U.S. Data U.S. economic data continues to broadly meet expectations, and the momentum in U.S. Treasury yields has overshot to the downside versus data surprises (bottom panel). Admittedly, there have been far fewer data releases of late because of the U.S. government shutdown last month. Yet even if the bulk of the unreleased data was weak, Treasury yields at current levels already seem to be discounting very soft growth. Forward-looking indicators of growth - the Conference Board leading economic indicator and BCA’s U.S. employment and capital spending models – are all pointing to the U.S. economy continuing to expand at a solid, above-trend pace in the coming months (Chart 4). Chart 4No Signs Pointing To Slower U.S. Growth The U.S. labor market remains tight, as evidenced by continued low unemployment and solid growth in wage measures like Average Hourly Earnings and the Wages and Salaries component of the Employment Cost Index (Chart 5). At the same time, readings from leading inflation indicators like the New York Fed’s Underlying Inflation Gauge remain elevated (bottom panel). The combined message is that U.S. core inflation rates will remain surprisingly sticky in the coming months, even given the lagged impact of last year’s drop in oil prices. Chart 5Persistent U.S. Inflation Pressures Many have made the case that the current cycle looks a lot like the Fed’s 2016 pause on policy tightening, which ended up lasting one full year after the December 2015 initial post-QE rate hike. Back then, the Fed’s more dovish posture helped generate easier financial conditions through a weaker U.S. dollar, tighter U.S. corporate credit spreads and higher U.S. equity values. U.S. Treasury yields fell sharply as the market aggressively covered a large bearish tilt towards U.S. interest rates while removing all rate hikes that were discounted for 2016 (Chart 6). There is one major difference between then and now, however – the U.S. economy is growing at a much faster pace, with far less spare capacity (bottom panel). Chart 6This Is NOT A Repeat Of 2016 When looking at all the U.S. data objectively, we conclude that the Fed’s latest dovish turn will not last anywhere near as long as the 2016 episode. The current easing of U.S. (and global) financial conditions alongside still-solid U.S. growth will eventually set up a return to the Fed rate hiking cycle, at a time when no interest rate increases are discounted in U.S. money markets. This supports our current recommendation to be tactically overweight U.S. corporate debt versus U.S. Treasuries on a 3-6 month horizon, during this window when the Fed is deliberately easing financial conditions by being overly dovish. On a more medium term 6-12 month horizon, however, we are maintaining a below-benchmark stance on U.S. duration exposure. The only way Treasury yields can move lower from here is if a Fed rate cutting cycle starts to be discounted – a highly unlikely scenario given the signals from leading growth and inflation indicators. Bottom Line: The Fed’s move to a more dovish posture is positive for global risk assets in the near-term. This is setting up for a revival of volatility later in 2019, however, with U.S. growth unlikely to slow enough to prevent inflation pressures from surfacing. With the market now discounting a stand-pat Fed over the next year, with minimal expected inflation, the risks for U.S. Treasury yields are now tilted to the upside. ECB Outlook – Firmly Neutral The euro area is currently facing a fairly significant growth slowdown. The manufacturing PMI has fallen for 13 consecutive months and now sits just above the 50 line indicating expanding growth. The OECD’s leading economic indicator (LEI) has also declined over that same period. Both indicators are now back to levels last seen prior to the 2009 and 2012 recessions (Chart 7). Chart 7Euro Area LEI and PMI Overstating The Downturn? Yet at the same time, surveys of business and consumer confidence from the European Commission suggest that the current downturn is nothing like those previous slumps. Even the Commission’s indicator of exporter order books (bottom panel) suggests that things do not appear as bad as indicated by the PMI and LEI. So where does the truth lie about the euro area economy? When looking at the hard data on exports (using the IMF’s Direction of Trade statistical database that includes both goods and services), it is obvious that there was a sharp slowing of euro area exports last year (Chart 8). Slumping Chinese demand was a major reason for that slowdown, but exports to the rest of the world also took a major hit. For the more export-intensive economies of Europe, last year’s global growth deceleration was a major punch to the gut. Chart 8European Export Shock Should Bottom Out Later In 2019 Looking ahead, there is still likely to be some pain coming from weaker export demand in the first half of 2019. The Chinese credit impulse (measured as a 12-month change in Total Social Financing as a % of GDP) is still negative, while our global LEI measure continues to drift lower. However, there are some tentative signs that things may be stabilizing. The shorter 6-month China credit impulse has hooked up (the “x’ in the top panel of Chart 8). Our diffusion index of countries within our global LEI – itself a leading indicator of the global LEI – has also begun to move higher, meaning there are fewer countries within the euro area with falling LEIs. While it is still too early to draw firm conclusions, there is a chance that euro area export growth will bottom out by mid-year. This is especially true if a U.S.-China trade detente is soon reached and Chinese policymakers deliver some additional growth stimulus measures, which is BCA’s base case scenario. ECB President Mario Draghi noted last week that a stabilization of global trade tensions would reduce much of the perceived uncertainty within the euro area economy. The U.S.-China trade spat has not been the only thing weighing on euro area growth, though. In our framework for analyzing the ECB’s policy decisions, we look at how broad-based are the trends in growth and inflation within the euro area to determine the next likely move on monetary policy. The way we do that is by looking at diffusion indices of economic data, constructed using figures from as many euro area countries as possible, given data availability. We show those diffusion indices for real GDP growth, manufacturing PMIs, headline inflation and core inflation in the euro area in Chart 9. Chart 9No Pressure On The ECB To Adjust Interest Rates The diffusion indices show that the vast majority of euro area countries are now suffering slowing real GDP growth and falling PMIs, with levels seen during recessions. Yet the actual pullbacks in real GDP growth and the PMIs have been shallower than those past episodes. It is as if today, all countries are suffering a slump, but no deep downturn. This is consistent with the ECB’s belief that Europe has suffered a bunch of one-off triggers for slowing growth – cutbacks in German auto production related to new emission standards, large-scale French street protests, the Italian fiscal policy debate with the EU, slowing exports from global trade tensions – but no broad-based decline that can be attributed to, or solved by, monetary policy. This is especially true with the diffusion index for core euro area inflation which now rising, suggesting that core inflation could remain surprisingly sticky in the coming months. The diffusion indices for euro area labor markets provide additional information as to why the ECB has not shifted to an even more dovish stance, despite the signs of weaker growth. Not only is the overall euro area unemployment rate now below the OECD’s estimate of the full employment NAIRU, the vast majority of countries within the euro area are at full employment (Chart 10). That diffusion index correlates strongly with a traditional Taylor Rule estimate of the equilibrium ECB policy rate, and suggests that the ECB should be raising rates right now. That can also be seen in the diffusion index for wage growth (bottom panel), which shows that the majority of euro area countries are seeing higher wage inflation. Chart 10Tightening Labor Markets In Europe Given the readings on the core inflation and labor market related diffusion indices, the current backdrop is not one where the ECB should be shifting to a more dovish posture. Yet when looking at market-based measures of inflation expectations like CPI swaps, investors clearly do not believe that the ECB’s optimistic inflation forecasts will be achieved over the next two years – typically a sign of policy settings that appear too tight (Chart 11). Chart 11Bund Yields Will Stay Subdued Without More Euro Area Inflation It will require some signs of euro area growth reacceleration, and maybe some upside surprises on core inflation and wage growth, before inflation expectations (and Bund yields) begin rising again. Those are unlikely to become visible until at least the latter half of 2019, and the ECB is likely to keep policy rates unchanged over the balance of the year. Given our relative views on the Fed and ECB, we see the scope for the yield spread between the benchmark 10-year U.S. Treasury and German Bund to widen from current levels. That spread is wide on a long-term basis because of the relative policy stance of the two central banks, with the current 255bps gap roughly equal to the gap between the fed funds rate and ECB refi rate. Yet the momentum of that spread is closely correlated to the difference in the data surprise indices for the U.S. and euro area, and a divergence has opened up between those two measures on the back of better U.S. growth (Chart 12). Chart 12UST-Bund Spread Has Overshot To Downside With the forward curves currently pricing in some additional tightening of the Treasury-Bund spread, betting on some renewed spread widening is a positive carry trade that also makes sense on a fundamental basis. Bottom Line: Growth has slowed in Europe, but the ECB is limited in its ability to ease policy further given tight labor markets and rising wage growth. Policy rates will stay on hold over at least the next year.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. The two main tail-risks are a messy Brexit and financial market volatility, but these are not our central case. Stay overweight the Eurostoxx50 versus the S&P500. Go underweight German bunds. Go overweight the German DAX versus German long-dated bunds. Add the German DAX as a new long position to the existing long basket holdings in France, Ireland and Switzerland. Maintain the short basket holdings in Norway and Denmark. Feature Chart of the WeekThe Underperformance Of German Equities Vs. German Bonds Is At A Euro Debt Crisis Extreme! Economies do not grow in straight lines. Rather, the process of economic expansion is a never-ending ebb and flow, creating clockwork-like oscillations in economic activity. As a perfect illustration, the growth in the euro area wage bill has trended higher through the past five years and is now running at very healthy 4 percent clip. Yet this strong uptrend has been interspersed with wobbles that have occurred with a remarkable regularity (Chart I-2). Chart I-2Economies Have Regular Wobbles... The recent setback in euro area activity has spooked some economy watchers. Even the ECB has just moved its risk assessment surrounding the growth outlook to the downside. But the downgrade was largely a result of its ‘data-dependency’ which, by definition, is always backward looking. This meant that the downgrade had a negligible effect on the financial markets which are always forward looking. For the markets, there is a much more important issue: is the recent setback the start of something serious, or can we expect a bounce back? The Setback The explanation for the regular wobbles in euro area growth comes from the oscillations in global economic activity (Chart I-3). But here we need to be wary of a potentially circular argument. As Europe is a dominant component of the global economy, euro area domestic demand setbacks could themselves be the root cause of the over-arching global growth oscillations. Chart I-3...Because Of Clockwork-Like Oscillations In Global Economic Activity Recently, Italy and Germany have suffered idiosyncratic ‘country and sector specific’ setbacks. The spat between Rome and Brussels over Italy’s 2019 budget caused Italian bond yields to soar and Italian bank lending to contract viciously (Chart I-4). Meanwhile, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German vehicle exports suffered a €20 billion hit which shaved 0.6 percent from the €3.4 trillion German economy (Chart I-5).  Chart I-4Italian Bank Lending Contracted Viciously, But Will Now Recover Chart I-5German Auto Exports Plunged, But Will Now Recover Despite all of this, the epicentre of the 2018 growth setback was not inside Europe, but outside Europe. The ECB correctly blames the recent down-oscillation not on domestic causes, but on softer external demand, specifically “vulnerabilities in emerging markets”. The central bank argues that once there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.  Another very important driver of European growth oscillations is the oil price. In recent years, the growth in GDP in excess of wages has perfectly and inversely tracked oscillations in the oil price (Chart I-6). The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending. Chart I-6Oil: Another Driver Of European Growth Somewhat contrary to received wisdom, one thing that does not generally drive euro area growth oscillations is the euro exchange rate. When the euro weakens, it does of course make the euro area’s exporters more competitive. But working against this, a weaker euro also raises the prices of imported energy and food, thereby squeezing euro area consumers’ real incomes. And vice-versa when the euro strengthens. Hence, while the euro’s moves do create growth winners and losers within the euro area, these tend to cancel out at the aggregate economy level. The Bounce Back The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. Regarding the vulnerabilities in emerging markets, many ECB governors argue that “everything we know says that the Chinese government is taking strong measures to address its slowdown”. Recent improvements in China’s monetary statistics provide strong evidence for this view (Chart I-7). Chart I-76-Month Credit Impulses Are Bouncing Back Everywhere Meanwhile, credit growth in the euro area itself is also accelerating, albeit modestly. This is hardly surprising given that financing conditions are very favourable. Even though the ECB has done nothing to policy interest rates, more dovish forward guidance has effectively made euro area monetary policy more accommodative: since October, core euro area 10-year bond yields are down 40 bps. And with banks’ balance sheets stronger, the ECB claims “the conditions for a continuation of credit to the economy are in place.”  Over the same three month period, the crude oil price has plunged by 35 percent (Chart I-8). Draghi confirmed our observation above: lower energy prices support real disposable income for euro area households. Chart I-8Double Boost: Lower Bond Yields And Lower Oil Draghi also pointed out another positive impulse: fiscal policy in the euro area has now flipped from contractionary to slightly expansionary. As regards the idiosyncratic sector specific setbacks, the Italian 10-year BTP yield has unwound its budget spat spike, and is down 100 bps since October. It follows that Italian bank credit growth is likely to recover. And Draghi explained that “the specific episode of the car industry in Germany will soon wash out because there is going to be a rebound in the sector.” Still, two significant tail-risks could smother the bounce back: Uncertainties related to geopolitical factors and the threat of protectionism, specifically, a messy Brexit. Financial market volatility. The Investment Implications Our central case is that the tail-risks do not materialise. And that the recent combination of more favourable financing conditions in the euro area and globally, lower energy prices, fiscal thrust, and the removal of specific setbacks in Italy and Germany should engineer some sort of growth bounce back in the euro area.  One important implication is that the strong recent rally in German bunds is close to exhaustion, and even vulnerable to a short-term retracement. This is supported by our trusted technical indicator warning of an imminent liquidity shortage and a corrective price reversal (Chart I-9). Go underweight German bunds on a short term horizon. Chart I-9The Rally In The German Bund Is Exhausted A mirror-image implication is that the underperformance of the German DAX relative to German long-dated bunds is now at euro debt crisis extremes (Chart I-1 and Chart I-10). This relative performance also appears technically exhausted and ripe for a reversal. As an asset allocation position, go overweight the DAX versus German long-dated bunds on a tactical. Chart I-10The Extreme Underperformance Of The DAX Will Reverse In line with the growth rebound thesis, stock market selection – through the underlying sector exposures – should now have a modest tilt towards cyclicality. Stay overweight the Eurostoxx50 versus the S&P500. Within Europe, our current long positions in France, Ireland, and Switzerland combined with short positions in Norway and Denmark do provide the required tilt towards cyclicality. Nevertheless, today we are adding the oversold German DAX to our long stock markets basket. Fractal Trading System* In line with the fundamentals-based arguments in the main body of this report, this week’s recommended trade is to go long the DAX versus the 30-year bund. Set a profit target of 2.5 percent with a symmetrical stop-loss 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, Senior Vice President 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

Special Report

Feature In the late 1980s, half of the global stock market capitalization resided in Japan Furthermore, almost a third of the Japanese stock market capitalization resided in banks. It followed that to have a view on the global stock market you had to have a view on Japanese banks. Indeed, in 1988, five of the ten largest companies in the world were Japanese banks. Less than ten years later, the weighting of Japanese banks in the global stock market had collapsed to less than one percent, rendering Japanese banks a largely irrelevant part of a global equity portfolio. In the new millennium, it was the turn of European banks to step into the limelight. By 2007, the proportion of the euro area's stock market capitalization in banks had ballooned to a quarter. And then, Europe followed in Japan's footsteps. Today, the weighting of banks in the Euro Stoxx has plunged to around a tenth. Could European banks now become a global investment irrelevance too (Feature Chart)? Feature ChartAre Europe's Banks Following In Japan's Footsteps? European banks have performed very poorly. From their peak in 2007, a one dollar investment in euro area banks relative to the world index would now be worth just 15 cents. But Japanese banks have performed abysmally: from their peak in the late 1980s, a one dollar investment in Japanese banks relative to the world index would now be worth a pitiful 3 cents (Chart I-2 and Chart I-3).1 Chart 2Japan Dominated The Global Stock Market In The Late 1980s Chart 3Banks Have Performed Abysmally What turned Japanese bank shares from heroes to zeroes? Some people point to sky-high valuations: in the late 80s, Japanese bank dividend yields dropped below 0.5 percent (Chart I-4), and these high valuations clearly contributed to their subsequent poor investment performance. But this was not the main reason. Chart 4Japanese Banks Offered Miserly Dividend Yields Banks' Lifeblood Is Credit Creation The main reason for the severe underperformance of Japanese banks was that they lost their lifeblood: credit creation. Put simply, if bank assets stop growing structurally, then it is impossible for bank revenues to grow structurally. But in Japan, it was worse: from the 1990s through the mid noughties, private sector indebtedness actually shrank from 220 percent to 160 percent of GDP, and this explains the bulk of the abysmal performance of bank equities (Chart I-5). Chart 5Banks' Lifeblood Is Credit Creation The important lesson is that the structural outlook for bank equities depends first and foremost on the structural outlook for bank credit creation. This is especially true in Europe because the majority of credit intermediation occurs via the banking system rather than via the bond market. So how can we assess the structural outlook for bank credit creation? Basically by noting that there appears to be an upper limit at which all the good lending has been done. Additional bank credit then generates misallocation of capital and mal-investments. At which point, the economy and bank asset quality start to suffer, limiting any further increase in profitable lending. The precise point at which this happens is not set in stone, because high levels of public indebtedness, through 'crowding out', can pull down the limit of productive private indebtedness. And vice-versa. Nevertheless when private indebtedness, as a percentage of GDP, reaches the mid-200s, the evidence suggests that the scope for further growth becomes limited. On this basis, the outlook for bank asset growth in Europe is a mixed bag. In Switzerland, Sweden and Norway, private indebtedness already stands at 250 percent of GDP, implying that the stock of profitable bank assets is close to its upper limit (Chart I-6). Chart 6In Switzerland, Sweden And Norway, Private Indebtedness Is Very High Meanwhile in the euro area, private indebtedness ratios in the Netherlands and Belgium are already well above 200 percent, and in France at 200 percent. On the other hand, the ratios in Germany and Italy - the largest and third largest euro area economies - are barely above 100 percent (Chart I-7). This bestows on them the honour of the lowest privately indebted major economies in the world (Chart I-8), with considerable theoretical capacity for bank asset growth. Admittedly, Italy has a high level of public indebtedness. Nevertheless, it is hard to deny that if the banking system in Italy could be unfrozen, there is great scope for economically productive lending. Chart 7In Germany And Italy, Private Indebtedness Is Very Low Chart 8In Japan, Private Indebtedness Has Plunged Having said all that, we now turn to something that bank investors everywhere in the world should fear: blockchain. Blockchain Is A Mortal Threat To Banks The internet's major innovation was to decentralize and democratize information. Before the internet, the creation, ownership and dissemination of information was a function centralized to privileged organizations: governments, media and entertainment companies. But after the internet, anybody and everybody could create, receive and share content - and this has proved to be a game changer for the governments, media and entertainment companies that previously owned and/or controlled the information. In the same way, blockchain's major innovation is to decentralize and democratize trust. The Economist even described blockchain as "the trust machine".2 It follows that blockchain will be a game changer for the privileged organizations whose raison d'être is to supply trust and integrity in transactions - essentially, those that act as a middleman. Clearly, one such privileged organization is the banking system, because the banking system is really nothing more than a middleman that provides trust and integrity in the transaction between the people with savings and the people who want to borrow those savings. Granted, banks also assess and price the credit risk of borrowers as well as provide a degree of insurance for savers. But with the prevalence of universal credit scoring systems and compensation schemes, there is a growing tendency to decentralize those functions too. Put simply, blockchain removes the need for a middleman. Until now, counterparties without an established trust relationship could only transact through a middleman who could add the trust and integrity overlay. But once each participant in the transaction trusts the blockchain itself, they no longer need to use a costly intermediary, like a bank. Therefore, just as the internet has revolutionized politics, media and entertainment, it is our very high conviction view that blockchain will revolutionize the way that money, assets and securities are held, transferred and accounted for. And the major casualty will be the banking system as we now know it. Investment Considerations The structural case for European banks is that Germany and Italy - the largest and third largest euro area economies - have considerable scope for bank credit expansion. The structural case against is that the other European economies have very limited scope for bank credit expansion. Furthermore, we confidently predict that within a decade blockchain will have decentralized and democratized financial intermediation, transforming it to something that is unrecognizable from today. Overall, this will not be a good thing for bank investors. With this in mind, German and Italian real estate and real estate equities are a much cleaner structural play on the potential for increased private indebtedness in those economies, whether intermediated by the banking system or not (Chart I-9 and Chart I-10). Chart 9The Evolution Of Private Indebtedness... Chart 10...Drives The Real Estate Market We end with another important lesson from Japan. Even in a three decade long bear market, the banks had the capacity for countertrend bursts of outperformance from oversold levels, sometimes by as much as 50 percent in a year. This is because even within a structural bear trend, there are cycles of excessive depression. European banks could be ripe for such a countertrend burst of outperformance. This year, European banks sank by 35 percent versus European healthcare. However, the sharp deceleration in global credit growth which dragged them down has now clearly reversed (Chart I-11). On this basis, the next six months could be a countertrend phase: a brief opportunity to own some European banks, at least relative to other equity sectors. Chart 11European Banks Are Ripe For A Burst Of Outperformance Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Performances are calculated in common currency terms. 2 Please see 'the trust machine', The Economist, October 31, 2015.

Special Report

Highlights So What? Chancellor Angela Merkel's decision to step down as party chairperson is positive for European political evolution and thus not a risk to the market. Why? The Christian Democratic Union (CDU) is unlikely to turn Euroskeptic, the median German voter is not. Europhile Green Party is surging, throwing shade at the narrative that Germans are souring on Europe. New elections are unlikely in the next 12 months, neither main centrist party would benefit. Chancellor Merkel's stabilizing role in the Euro Area crisis is overstated. Infusion of new blood is precisely what Germany, and Europe, needs. Also... 2019 will be a big year for Europe with multiple decisions to be taken on governance reforms. New leadership in Berlin is exactly what the doctor ordered. Feature German Chancellor Angela Merkel's Christian Democratic Union (CDU) suffered a deep loss in the Hesse election on October 28. Germany's main centrist parties - the center-right CDU and center-left Social Democratic Party (SPD) - suffered deep losses in Hesse, mirroring the results in Bavaria from October 14 (Chart 1). The results have prompted Angela Merkel to confirm that she will not stand for re-election as chair of the CDU at the Hamburg party convention and that she will not seek any political posts after her current term as chancellor ends in 2021. Chart 1Winners And Losers In Bavaria And Hesse In this Client Note, we examine what Chancellor Merkel's decision means for Germany and Europe. Are Euroskeptics Taking Over Germany? The most important question for global investors is whether Merkel's fall from grace is related to a growing trend of populism in Europe. In part, yes. However, Merkel's problem is deeper. Merkel-fatigue in Germany has deeper roots than her decision on immigration in 2015. Polling suggests that Merkel recovered from that crisis and reached a 70% approval rating in mid-2017, only to see a precipitous decline since (Chart 2). Chart 2Merkel's Political Capital Is Spent That said, German Euroskeptic sentiment is not on the rise (Chart 3). In fact, Germans support the currency union at one of the highest clips in Europe. Furthermore, Germans continue to "feel" European (Chart 4). Chart 3Germans Are Europhile... Chart 4...And Feel Quite European In the last two Lander elections in Bavaria and Hesse, the right-wing, Euroskeptic party Alternative for Germany (AfD) underperformed its national polling. Its support in opinion polls, at 16%, appears to be limited by the number of Germans who identify as Euroskeptic, similarly around 14%. In fact, it was the Green Party that surprised in both Bavaria and Hesse, gaining 8.9% and 8.7% respectively. Bottom Line: The short answer is no, Germany is not being taken over by Euroskeptics. True, the 2015 migration crisis has given the AfD a tailwind, allowing it to become entrenched in the political system. Yet just as impressive is the rise of the Europhile Green party (Chart 5). Chart 5Grand Coalition Parties Would Be Crazy To Call A New Election OK, But Will The CDU Move To The Right? The previous question was purposely hyperbolic. The more nuanced question is whether the CDU will swing to the right in the face of AfD's rise? The answer depends on the issue. The two key issues are immigration and EU integration. On immigration, it is simply good politics for Germany's center-right party to steal from the AfD platform. The only downside of adopting a right-leaning immigrant policy is that it will make forming coalitions with the surging Green Party more difficult. It was immigration policy that ultimately prevented the so-called Jamaica Coalition - the CDU, the Green Party, and the pro-business and mildly Euroskeptic Free Democratic Party (FDP) - from becoming a fully-fledged ruling coalition in November 2017. This forced Merkel to re-establish the uninspiring Grand Coalition with the SPD.1 On European integration, it is possible that the CDU will adopt more Euroskeptic rhetoric, but such a move could backfire. First, data suggests that Germans continue to support the euro at a high clip. Second, AfD has already captured the "hard Euroskeptic" voters, whereas FDP has captured "soft Euroskeptics." It is unclear if the CDU has any chance of getting any of those voters back by crowding the "Euroskeptic corner." In fact, data from Bavaria and Hesse indicate that the CDU has been losing voters equally to the Green Party and the AfD. From the perspective of the Median Voter Theory, the CDU has a clear path forward. By remaining Europhile and pro-EU, it can ensure that it does not abandon the 83% of Germans who continue to support the currency union. The German median voter clearly does not want to abandon European institutions. But by ditching Merkel's liberal, pro-immigrant policy, the CDU can ensure that it withstands the AfD's attack on its right flank. Bottom Line: Germany's main center-right party has the luxury of picking its battles with the right-wing AfD. We suspect that the CDU will adopt some of the AfD's anti-immigrant rhetoric and policy, but retain its centrism on other issues. Who Will Replace Merkel As The Head Of The CDU? After months of speculation, Chancellor Merkel has confirmed that she will not pursue the CDU chairmanship at the upcoming December 7-8 party conference in Hamburg. Instead, Germany's ruling party will select a new chairperson, one who will be groomed as Merkel's successor for the 2021 election. The process for selecting the CDU chairperson is largely closed and dominated by party elites. The Federal Executive Board of the CDU - which is made up of the chairperson and 39 other members - sits down with the CDU parliamentary faction to approve the candidates, ensuring that a rogue candidate cannot stage a surprise in the delegate vote. It is highly likely that Merkel will be able to hand-pick a successor. Table 1 is our attempt to collate the likeliest candidates to replace Merkel as the head of the CDU. The list includes only one Euroskeptic candidate - former party whip Friedrich Merz who has not sat in the Bundestag since 2009 - and quite a few outright Europhiles. Merkel's preferred candidate is Annegret Kramp-Karrenbauer - often referred to by German media by her acronym AKK - a centrist who is to the left of Merkel on economic policy, EU matters, and social issues. Table 1Potential Merkel Successors Given the short period of time between now and the Hamburg conference, it is highly unlikely that a surprise candidate - such as the Euroskeptic Merz - will emerge victorious. Merkel, for instance, spent months grooming the party rank-and-file prior to her nomination. Bottom Line: Merkel's successor is likely to be hand-picked. Will Merkel Survive Until 2021? Merkel's chances of staying in power until the end of the current government's term will increase if her favored successor - Kramp-Karrenbauer - emerges victorious in December. A win for an outsider, or someone highly critical of Merkel (such as Jens Spahn, who has disagreed with Merkel on immigration), might hasten Merkel's demise. How would such an outcome play out? If Merkel resigns, the Bundestag would have to elect a new chancellor with a simple majority. Given that the CDU currently governs in a coalition with the SPD, the latter party would have to support the election of a new chancellor. Kramp-Karrenbauer would be acceptable to the SPD, but one of the more contentious candidates may not. A new election would require the chancellor - Merkel or her successor - to lose a confidence vote that he or she has called. However, this is a controversial matter constitutionally as the government must claim that it has reached a legislative impasse on a particular issue. (Chancellor Gerhard Schroder argued in 2005 that his economic agenda was stalled.) The other question is why would either of the ruling parties want new elections at this point? Both centrist parties are tanking in the polls, as both Bavarian and Hesse elections signal and as overall polling indicates (see Chart 5). As such, we suspect that a new election will not take place over the next 12 months, at the very least. Bottom Line: Early elections are not easy to arrange and neither of the two ruling parties want one at the moment. Merkel has at least one more year in power. Investment Implications: Does Any Of This Matter? Chancellor Merkel has lost all of her political capital: that much is clear. As such, her decision to begin the process of finding a successor is a positive development, one that political leaders rarely take willingly. Given the election of a Europhile Emanuel Macron in France in 2017, Berlin needs to find a comparable partner that can carry on reforms. Otherwise, Germany risks wasting the window of opportunity afforded by the Macron presidency to make critical changes to Euro Area governance. On the agenda over the next year or two are several important issues. First, the European Stability Mechanism (ESM) is supposed to be granted new powers, evolving it into a kind of European replacement for the IMF. Some argue - including the ESM's leadership - that this expanded role will necessitate a greater injection of capital, for which obviously Berlin must be on board. Second, the stalled Banking Union project requires Berlin's intimate involvement. A deposit insurance union would go a long way toward stabilizing the Euro Area amid future financial crises. Under Merkel, Berlin has been reticent to greenlight such developments. Third, Berlin must agree with EU peers on several important positions after the European Parliament elections in May 2019. These will include staffing the European Commission. According to press reports this summer, Merkel was focused on ensuring that the next president of the European Commission would be a German. To get her way, Chancellor Merkel supposedly indicated that she would not fight to get a German to replace Mario Draghi, whose term at the ECB is set to expire in October 2019. A change at the top in Berlin, particularly if a Euroskeptic takes over the CDU, may signal a reversal of this strategy. That said, what Berlin wants is not necessarily what Berlin will get, no matter who is in charge. Finally, there is the philosophical question of whether Merkel has been a factor of stability for Europe over the past decade. We believe the answer is no. Not for any normative reason but rather because she has been an intently domestic chancellor. Investors have been overstating Merkel's role as the "anchor" of Euro Area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent Euro Area fiscal backstop mechanism due to the upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. Such delays and hesitations have cost Europe considerable momentum throughout the crisis and since. As such, we believe that Chancellor Merkel's decision presents considerable upside for European politics and limited downside. Infusion of new blood in Berlin is the only way for Europe to restart the stalled governance reforms. However, much will depend on whether the CDU takes a significant turn towards a "softer Euroskeptic" position or maintains its traditional pro-European outlook. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 The name references the colors of the three parties (black for CDU, green for the Green Party, and yellow for the FDP).

Special Report

Highlights The Global Golden Rule (GGR): The gap between market expectations of global central bank policy rates and realized interest rate outcomes is a reliable predictor of government bond returns. Thus, "getting the policymaker call right" is the key to outperformance for bond investors. Implied Government Bond Yields: Given the strong correlation between policy rate surprises and government bond yield changes, we can use the GGR to forecast yields one year from now based on our own assumptions of how many rate hikes (cuts) will be delivered versus what is discounted in money market yield curves. Total Return Forecasts: We can use implied government bond yield changes from the GGR to generate expected 12-month total returns for government bond indexes of different maturities, taking into account different rate hike assumptions for various central banks. Feature Chart 1Global Monetary Divergences? This month marked the ten-year anniversary of the 2008 Lehman Brothers default, which set off a worldwide financial crisis and a massive easing of global monetary policy. Extraordinary measures - zero (or negative) interest rates, large-scale asset purchases and dovish forward guidance from policymakers - were all successful in suppressing both global bond yields and volatility over time, helping the global economy slowly heal from the crisis. Now, a decade later, such hyper-easy monetary policies are no longer required given low unemployment rates and rising inflation in the major developed economies. That can be seen today with the Federal Reserve shifting to "quantitative tightening" (letting bonds run off its swollen balance sheet) alongside steady rate hikes, the European Central Bank (ECB) set to stop net new buying of euro area bonds at year-end, and the Bank of Japan (BoJ) dramatically slowing its pace of asset purchases. BCA's Central Bank Monitors, which assess the cyclical pressure on policymakers to tighten or ease monetary policy, have collectively been calling for interest rate increases since the start of 2017. Yet our Central Bank Monetary Barometer, which measures the percentage of central banks that have tightened policy over the previous three months, shows that only 1 in 5 banks have actually delivered rate hikes of late (Chart 1). Thus, the risks are tilted towards more countries moving away from highly accommodative monetary conditions given tightening labor markets and rising inflation pressures. This now-global shift towards policy normalization has major implications for global bond investing. The focus is now returning back to more traditional drivers of government bond returns, like changes in central bank policy rates. We recently shared a Special Report published by our colleagues at our sister BCA service, U.S. Bond Strategy, describing a methodology they dubbed "The Golden Rule of Bond Investing".1 That report introduced a numerical framework that translates actual changes in the U.S. fed funds rate relative to market expectations into return forecasts for U.S. Treasuries. The historical results convincingly showed that investors who "get the Fed right" by making correct bets on changes in the funds rate versus expectations were very likely to make the right call on the direction of Treasury yields. In this Special Report, we extend that Golden Rule analysis to government bonds in the other major developed markets (DM). Our conclusion is that utilizing a "Global Golden Rule" (GGR) framework that links bond returns to unexpected changes in policy rates can help bond investors correctly forecast changes in non-U.S. bond yields. The report is set up in two sections. First, we illustrate how the GGR works and how it empirically tends to generally succeed over time for different DM bond markets. In the second section, we make use of the GGR to generate expected return forecasts for non-U.S. government bonds for a variety of interest rate "surprise" scenarios. ECB Policy Rate Surprises Dovish surprises from the ECB do reliably coincide with positive German government bond excess returns versus cash (Chart 2A). Chart 2AECB Policy Rate Surprise & Yields I Chart 2BECB Policy Rate Surprise & Yields II The 12-month ECB policy rate surprise and the 12-month change in the Bloomberg Barclays German Treasury index yield displays a strong positive correlation (Chart 2B). The excess returns during periods of dovish surprises is 14.4% on average and are positive 85% of the time. Hawkish surprises on the other hand, coincide with negative average excess returns of -1.5% (Chart 2C). In terms of total return, the picture is roughly the same except that under hawkish surprises, the average total return you would expect is now positive, given that it factors in coupon income (Chart 2D). Chart 2CGermany: Government Bond Index Excess Return & ECB Policy Rate Surprises (2004 - Present) Chart 2DGermany: Government Bond Index Total Return & ECB Policy Rate Surprises (2004 - Present) Table 1Germany: 12-Month Government Bond Index Returns And Rate Surprises (2004 - Present) Looking ahead, the ECB should not deviate from its current dovish forward guidance of no interest rate hikes until at least the third quarter of 2019. That is somewhat consistent with the reading of the ECB monitor being almost equal to zero. Bank Of England (BoE) Policy Rate Surprises The GGR works well for the U.K. as can be seen in Chart 3A. Chart 3ABoE Policy Rate Surprise & Yields I Chart 3BBoE Policy Rate Surprise & Yields II The 12-month BoE policy rate surprise and the 12-month change in the Bloomberg Barclays U.K. Treasury index yield displays a strong positive correlation except for a major divergence in 1997-1998 (Chart 3B). Dovish surprises coincide with positive excess returns over cash 78% of the time and are on average equal to 6.2% over the full sample (Chart 3C and Chart 3D). As you would expect if the GGR applies, hawkish surprises coincide with negative excess returns. Chart 3CU.K.: Government Bond Index Excess Return & BoE Policy Rate Surprises (1993 - Present) Chart 3DU.K.: Government Bond Index Total Return & BoE Policy Rate Surprises (1993 - Present) Table 2U.K.: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, outcomes will be biased toward dovish surprises over the next six months given the uncertain outcome of the U.K.-E.U. Brexit negotiations. Against that backdrop, the BoE will remain accommodative despite inflationary pressures building up. Bank Of Japan (BoJ) Policy Rate Surprises The GGR does not seem to work when it comes to the Japanese bond market. This reflects the fact that both the markets and the Bank of Japan (BoJ) have understood that chronic low inflation has required no changes in BoJ policy rates (Chart 4A, second panel). Chart 4ABoJ Policy Rate Surprise & Yields I Chart 4BBoJ Policy Rate Surprise & Yields II While the 12-month BoJ policy rate surprise and the 12-month change in the Bloomberg Barclays Japan Treasury index yield displayed a strong positive correlation pre-1998, the correlation has broken down since then (Chart 4B). Negative excess returns over cash both coincide with dovish and hawkish surprises, on average over time. Further, dovish surprises coincide with positive excess returns only 45% of the time (Chart 4C and Chart 4D). Chart 4CJapan: Government Bond Index Excess Return & BoJ Policy Rate Surprises (1994 - Present) Chart 4DJapan: Government Bond Index Total Return & BoJ Policy Rate Surprises (1994 - Present) Table 3Japan: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) Looking ahead, given that the BoJ will in all likelihood maintain its ultra-accommodative monetary policy stance in the near future, we do not expect the GGR to become more effective when applied to the Japanese bond market. Bank Of Canada (BoC) Policy Rate Surprises The GGR works relatively well for the Canadian bond market (Chart 5A). Chart 5ABoC Policy Rate Surprise & Yields I Chart 5BBoC Policy Rate Surprise & Yields II We observe a tight correlation between 12-month BoC policy rate surprises and the 12-month change in the Bloomberg Barclays Canada Treasury index yield, especially post-2010 (Chart 5B). Dovish surprises coincide with positive excess returns 81% of the time and 94% of the time if we look at total returns (Chart 5C and Chart 5D). Chart 5CCanada: Government Bond Index Excess Return & BoC Policy Rate Surprises (1993 - Present) Chart 5DCanada: Government Bond Index Total Return & BoC Policy Rate Surprises (1993 - Present) Table 4Canada: 12-Month Government Bond Index Returns And Rate Surprises (1993 - Present) Looking ahead, the BoC will most likely continue to follow the tightening path of the Federal Reserve, admittedly with a lag. However, accelerating inflation at a time when there is no spare capacity in the Canadian economy suggests that the BoC could deliver more rate hikes than are already priced for the next 12 months. As shown in Table 4, hawkish surprises from the BoC do coincide with negative monthly excess returns of -2.8%. Reserve Bank Of Australia (RBA) Policy Rate Surprises The GGR applies extremely well to the Australian bond market (Chart 6A). Chart 6ARBA Policy Rate Surprise & Yields I Chart 6BRBA Policy Rate Surprise & Yields II The 12-month RBA policy rate surprise and the 12-month change in the Bloomberg Barclays Australia Treasury index yield displays the tightest correlation out of all the countries covered (Chart 6B). Dovish surprises coincide with positive excess returns 83% of the time and 96% of the time if we look at total returns (Chart 6C and Chart 6D). Turning to hawkish surprises, they reliably coincide with negative excess returns. Chart 6CAustralia: Government Bond Index Excess Return & RBA Policy Rate Surprises (1994 - Present) Chart 6DAustralia: Government Bond Index Total Return & RBA Policy Rate Surprises (1994 - Present) Table 5Australia: 12-Month Government Bond Index Returns And Rate Surprises (1994 - Present) As can be seen on the bottom panel of Chart 6A, the RBA Monitor has been rapidly falling since 2016 and now stands in the "easier monetary policy" required. However, the RBA will likely have to see a rise in unemployment or a decline in realized inflation before it considers cutting rates, which raises a risk of "hawkish" surprises if the market begins to price in rate cuts. Reserve Bank Of New Zealand (RBNZ) Policy Rate Surprises The GGR works fairly well for Nez Zealand (NZ) government bonds (Chart 7A). Chart 7ARBNZ Policy Rate Surprise & Yields I Chart 7BRBNZ Policy Rate Surprise & Yields II 12-month RBNZ policy rate surprises and the 12-month change in the Bloomberg Barclays NZ Treasury yield exhibit a decent correlation (Chart 7B). Unusually, NZ is the only bond market covered in this report where both dovish and hawkish surprises coincide with positive excess returns on average, although positive episodes are much less frequent for hawkish surprises than for dovish surprises; respectively 55% and 86% (Chart 7C and Chart 7D). Chart 7CNZ: Government Bond Index Excess Return & RBNZ Policy Rate Surprises (2000 - Present) Chart 7DNZ: Government Bond Index Total Return & RBNZ Policy Rate Surprises (2000 - Present) Table 6New Zealand: 12-Month Government Bond Index Returns And Rate Surprises (2000 - Present) Looking ahead, the RBNZ has already provided forward guidance indicating that the Overnight Cash Rate (OCR) will most likely stay flat until 2020 - an assessment that we agree with, so the odds are against any policy surprises over at least the next 6-12 months. Using The Global Golden Rule To Forecast Government Bond Returns The practical application of the GGR is that it can be used as a framework for generating expected changes in yields and calculating total return forecasts for global government bond indices. The strong correlation demonstrated in the previous section between the 12-month policy rate surprises and the 12-month change in the average yield from the government bond indexes allows us to translate our "assumed" policy rate surprise over the next 12 months into expected changes in yields along the curve. With these expected yield changes, we can simply generate expected total returns using the following formula: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility It is important to note that we would not give too much importance to what this analysis yields for longer-dated bonds. As shown in the Appendices, once we move into longer government bond maturities, the correlation between the policy rate surprise and the change in yields declines or even becomes non-existent for some countries. This result should not be surprising, as longer-term yields are driven by other factors besides simply changes in interest rate expectations. Inflation expectations, government debt levels and demand from longer-term investors like pension funds all can have a more outsized influence on the path of longer-term bond yields relative to the shorter-end. That results in much more uncertainty when it comes to the total return forecasts for long-dated maturities calculated with this framework. Practically speaking, we are not encouraging our readers to blindly follow that yield and return expectations generated by the GGR, even for bond markets where it clearly seems to be working over time. Rather, the GGR can be integrated in a larger asset-allocation framework for a global fixed-income portfolio by providing one possible set of bond market outcomes. On a total return basis, the results presented below, interpreted alongside the readings on the BCA Central Bank monitors, suggest that investors should be underweight core Euro Area (Germany, France and Italy), Australia and New Zealand while remaining overweight the U.K. and Canada over the next twelve months. As for Japan, given the likelihood that BoJ will leave its policy rate flat, the results hint at a neutral allocation. Jeremie Peloso, Research Analyst jeremie@bcaresearch.com Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com. 2 Please see Global Fixed Income Strategy Weekly Report, "BCA Central Bank Monitor Chartbook: Divergences Opening Up," dated September 19, 2018, available at gfis.bcaresearch.com. Global Golden Rule: Germany In light of the forward guidance ECB President Mario Draghi has been providing to the markets, it appears that the most likely scenario over the next 12 months is for the ECB to keep interest rates on hold. Based on the strong relationships between 12-month ECB policy rate surprises and 12-month changes in yields along the curve (Appendix A), a flat interest rate scenario would be bond bearish for German government bonds especially at the short end of the curve with the 1-year German yield expected to rise by 16bps (Table 7A). Table 7AGermany: Expected Changes In Bund Yields Over The Next 12 Months (BPs) Using the expected change in yields thus inferred by the policy rate surprise, the German government bond aggregate index is forecasted to return 0.45% over the next 12 months (Table 7B). Table 7BGermany: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: U.K. Markets are currently discounting only 21bps of rate hikes in the U.K. over the next year. Thus, even a scenario where the BoE delivers only a single 25bp rate hike would be bearish for U.K. Gilts, especially at the short-end of the curve. Applying the GGR, 1- and 3-year Gilt yields would be expected to rise by 20bps and 10bps respectively (Table 8A). Table 8AU.K.: Expected Changes In Gilt Yields Over The Next 12 Months (BPs) Interpolating these expected yield changes, the 1-3 year government bond index total return forecast would be 0.46%. On the other hand, if the BoE prefers to keep rates on hold given the uncertainty of the Brexit outcome, that same 1-3 year government bond index is forecasted to deliver 0.97% of total return over the next 12 months (Table 9B). This is our current base case scenario for Gilts. Table 8BU.K.: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Japan Despite many rumors to the contrary earlier this year, the base case view remains that the BoJ will not change its stance on monetary policy anytime soon. As such, the expected changes in JGB yields under a flat interest rate scenario over the next 12 months are close to zero at the short end of the curve and rather bond bullish at the longer end of the curve; for instance, the 30-year JGB yield would be expected to rally by 9bps (Table 9A). Table 9AJapan: Expected Changes In JGB Yields Over The Next 12 Months (BPs) In that most likely scenario, the Japanese government bond index is forecasted to deliver 0.83% of total return over the next 12 months. In the event that the BoJ surprises the markets by delivering one rate hike of 25bps, it would be bond bearish for JGBs and the total return forecasts for the government bond indices would be negative, regardless of the maturity (Table 9B). Table 9BJapan: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Canada Will the Bank of Canada follow the footsteps of the Fed? The markets certainly seem to think so, with more than three 25bps rate hikes priced in for next 12 months in the OIS curve. Table 10ACanada: Expected Changes In Government Bond Yields Over The Next 12 Months (BPs) That scenario would be outright bearish for Canadian government bonds, with 1- and 2-year yields rising by 16bps and 21bps, respectively (Table 10A). In terms of total returns, the GGR framework forecasts that with 75bps of rate hikes, the Canadian government bond aggregate index would deliver a positive return of 2.35% (Table 10B). This is because 75bps of hikes are currently discounted in the Canadian OIS curve, thus it would neither be a hawkish nor dovish surprise. Table 10BCanada: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: Australia The RBA Monitor just dipped below the zero line, implying that easier monetary policy is required based on financial and economic data. Table 11A shows that a rate cut delivered by the RBA in the next 12 months would be bond bullish for Aussie yields, especially at the long end of the curve, where the 30-year Aussie bond yield would fall by 34bps. Table 11AAustralia: Expected Changes In Aussie Yields Over The Next 12 Months (BPs) Of all the interest rate scenarios presented in Table 11B, the two rate cut scenarios would return the highest total returns. For instance, the Australian government bond aggregate index would return 2.80% and 3.90% in the event of one and two 25bps rate hikes, respectively. Table 11BAustralia: Government Bond Index Total Return Forecasts Over The Next 12 Months Global Golden Rule: New Zealand Our view is that the Reserve Bank of New Zealand will stay on hold for a while longer, which is broadly the same message conveyed by the RBNZ Monitor being positive, but very close to 0. With that in mind, a flat interest rate scenario appears to be bond bearish for the NZ bond yields, except for the longer end of the curve (Table 12A). Table 12ANew Zealand: Expected Changes In NZ Yields Over The Next 12 Months (BPs) Table 12BNew Zealand: Government Bond Index Total For New Zealand, the government bond aggregate bond index is the only index provided by Bloomberg Barclays, as opposed to the other countries in our analysis where different maturities are given. In the flat interest rate scenario, the total return forecast for the overall index would be of 2.53% over the next 12 months. Appendix A: Germany Chart 1Change In 1-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 2Change In 2-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 3Change In 3-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 4Change In 5-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 5Change In 7-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 6Change In 10-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 7Change In 30-Year German Bund Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix B: France Chart 8Change In 1-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 9Change In 2-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 10Change In 3-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 11Change In 5-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 12Change In 7-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 13Change In 10-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 14Change In 30-Year French OAT Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix C: Italy Chart 15Change In 1-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 16Change In 2-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 17Change In 3-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 18Change In 5-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 19Change In 7-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 20Change In 10-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Chart 21Change In 30-Year Italian Gov't Bond Yield##BR##Vs. 12-Month ECB Policy Rate Surprise Appendix D: U.K. Chart 22Change In 1-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 23Change In 2-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 24Change In 3-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 25Change In 5-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 26Change In 7-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 27Change In 10-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Chart 28Change In 30-Year Gilts Yield##BR##Vs. 12-Month BoE Policy Rate Surprise Appendix E: Japan Chart 29Change In 1-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 30Change In 2-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 31Change In 3-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 32Change In 5-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 33Change In 7-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 34Change In 10-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Chart 35Change In 30-Year Japanese JGB Yield##BR##Vs. 12-Month BoJ Policy Rate Surprise Appendix F: Canada Chart 36Change In 1-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 37Change In 2-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 38Change In 3-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 39Change In 5-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 40Change In 7-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 41Change In 10-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Chart 42Change In 30-Year Canadian Yield##BR##Vs. 12-Month BoC Policy Rate Surprise Appendix G: Australia Chart 43Change In 1-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 44Change In 2-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 45Change In 3-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 46Change In 5-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 47Change In 7-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Chart 48Change In 10-Year Aussie Yield##BR##Vs. 12-Month RBA Policy Rate Surprise Appendix H: New Zealand Chart 49Change In 1-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 50Change In 2-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 51Change In 3-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 52Change In 5-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 53Change In 7-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise Chart 54Change In 10-Year NZ Yield##BR##Vs. 12-Month RBNZ Policy Rate Surprise

Highlights German real estate and real estate equities remain a worthwhile multi-year position, especially in relative terms. The dominant stocks are Vonovia, Deutsche Wohnen, LEG, and GSW. Swedish real estate and real estate equities are likely to face harder times. The dominant stocks are Lundbergforetagen, Castellum, Fastighets, and Fabege. The structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian real estate offers distressed opportunities. The long-term equity play is Covivio. We remain reluctant to own U.K. residential real estate or real estate equities. Chart of the WeekExtremes In European Real Estate Feature Nowadays, the best way to play the relative performance of an individual economy is through real estate. Indeed, European real estate offers compelling structural opportunities for investors who want to go long, and for investors who want to go short. By contrast, the opportunities to play intra-European economic divergences through other asset-classes have become limited. Nineteen European countries share one currency and one policy interest rate; and the mega-cap companies that drive the major equity indexes are multinationals exposed to the global economy. Meaning that a stock market's relative performance is no longer defined by its home economy; it is now defined instead by its dominant sectors and stocks.1 This leaves real estate as the purest play on the domestic economy. The evidence comes from the huge divergences in real estate market performances across Europe through the past two decades (Chart I-2-Chart I-4). While house prices in Sweden and Norway have more than trebled in real terms, house prices in Germany and Italy are at the same real level today as in 1995 (Chart of the Week). Chart I-2Winners And Losers In##br## European Real Estate Chart I-3Winners And Losers In##br## European Real Estate Chart I-4Winners And Losers In##br## European Real Estate How can German real estate be such a massive structural underperformer when the German economy has been one of Europe's star performers? The answer is that house prices take their cue from wages. German wages were suppressed for more than a decade, from which they are now playing a long catch up. A Tale Of Two Real Estate Markets: Germany And Sweden The two long-term drivers of house prices, assuming no supply bottlenecks, are: Real wages. The availability and price of bank credit. Real rents should trend higher to reflect the increasing quality of accommodation. For example, kitchens and bathrooms, heating and cooling systems and home security should all get better. In essence, the quality of accommodation benefits from productivity improvements. Of course, such improvements require investment expenditure. But a real estate investor requires a return on this investment. Therefore, rents - even after expenses - should increase in real terms. Given that house prices must maintain some long-term connection with rents, house prices should also trend higher in real terms, reflecting the improvements in home quality. But if real wages are not rising, it is impossible for tenants to absorb higher real rents, and so real rents and house prices stagnate. This describes the situation in Germany through 1995-2010 when labour market reforms resulted in real wages going nowhere, despite major gains in workers' real productivity (Chart I-5). Furthermore, as nominal adjustments to rents occur infrequently, German real rents and house prices actually fell through this extended period (Chart I-6). Chart I-5Through 1995-2010 German##br## Real Wages Stagnated... Chart I-6...So German Real Rents And ##br##House Prices Declined Since 2010, the dynamic has reversed. Needing to catch up with the economic fundamentals, German real wages, real rents and house prices have all rebounded very strongly. Nevertheless, based on the long-term connection with real productivity gains, German real rents and house prices have considerable further catch up potential. Just fifty miles across the Baltic Sea, the opposite is true. In Sweden - and Norway - house prices appear to have run well ahead of the economic fundamentals. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that the flood of bank credit has been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated bank credit fuelled bubbles... albeit in Sweden and Norway. Real estate equities are just a leveraged play on rents - and thereby real estate capital values - because the companies take on debt to finance their property portfolios. This means that in the short term, they are (inversely) sensitive to bond yields, but in the long term the main driver is rental growth. Hence, in the German real estate market's post-2011 rebound, German real estate equities - now dominated by Vonovia, Deutsche Wohnen, LEG, and GSW - have trebled (Chart I-7), and the market relative trade is up a very pleasing 75 percent since we initiated it. Any rise in bond yields would be a short term drag, but given that real rents and house prices have further catch-up potential, the sector remains a worthwhile multi-year position, especially in relative terms. Chart I-7German Real Estate Equities ##br##Have Trebled Since 2012 Interestingly, Swedish real estate equities have also trebled in the post-2011 period (Chart I-8). But in Sweden's case, house prices are extended relative to the economic fundamentals. Swedish real estate equities - now dominated by Lundbergforetagen, Castellum, Fastighets, and Fabege - are likely to face harder times. Chart I-8Swedish Real Estate Equities ##br##Have Also Trebled Since 2012 Hence, the structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian Real Estate Offers Distressed Opportunities Turning to Italian real estate, it has exhibited the mirror-image pattern of Germany. From the late nineties to 2008, Italian house prices almost doubled in real terms - only then to enter a ten year bear market. In recent years, Italian real wages have been growing again, raising the question: what is holding back Italian house prices? The answer is a banking system that will not lend, making it difficult for anybody to finance a house purchase (Chart I-9). Chart I-9Italian Banks Haven't Been Lending... This lack of bank financing means that the natural flow of real estate that has to find a new owner is not receiving any bids. The upshot is that a long-term investor who can access financing can pick up property at highly distressed valuations, often at a fraction of the market price a few years ago. Some investors cannot remove a nagging fear about an 'Italexit' from the monetary union and the deep crisis that would follow. It is precisely because of the deep crisis that would ensue from a euro breakup that its likelihood remains low - though admittedly not zero. But even in that extreme eventuality, as long as Italy did not become an outlaw state in which property rights were dismantled, a long-term investor might still fare well. Because he would own a real asset bought at a very distressed price. Within the stock market, the real estate equity sector in Italy - just as in Germany and Sweden - has been a leveraged play on the house price cycle (Chart I-10). But there are two caveats: the sector is tiny with one dominant company, Beni Stabili; and Beni Stabili has just been taken over by the French property company Covivio. Still, now that Covivio owns a large portfolio of Italian real estate assets, it would be the appropriate equity to play this multi-year theme. And the bonus is that it offers a dividend yield of 5 percent. Chart I-10...Creating Distressed Opportunities In Italian Real Estate U.K. Real Estate Faces Headwinds Finally, the recent pressure on U.K. house prices is likely to persist (Chart I-11) - with the housing market facing at least one of three potential headwinds: Chart I-11U.K. Real Estate Faces Headwinds A disorderly Brexit, though not our central case, would pose a huge risk for the U.K. economy. On the other hand, an orderly and smooth transition to Brexit would liberate the Bank of England to hike interest rates further in 2019. Bear in mind that in the U.K., wage pressures and CPI inflation are not dissimilar to those in the U.S., where the Federal Reserve has already hiked the policy rate seven times. So it is largely the uncertainties surrounding Brexit that are staying the BoE's hands. The precarious path to leaving the EU on March 29 2019 is littered with landmines for Theresa May. Any of these landmines could trigger a snap General Election, a Jeremy Corbyn led Labour government, and the spectre of a high-end 'land value' tax. Hence, we remain reluctant to own U.K. residential real estate or real estate equities. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For the compelling evidence, please see Charts 1-6 in the European Investment Strategy Weekly Report 'The Eight Components Of Equity Market Allocation' July 26 2018 available at eis.bcaresearch.com. Fractal Trading Model* The 30% outperformance of India versus China during the recent EM shock is technically stretched, hitting a fractal dimension that signals a potential reversal, assuming no further deterioration in news flow. On this technical basis, the countertrend trade would be long China/short India with a profit target of 9% and symmetrical stop-loss. In other trades, long platinum/short nickel reached the end of its 65 day holding period very comfortably in profit. However, short consumer services versus consumer goods hit its stop-loss. This leaves five open trades. 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-12 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions 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