Consumer Discretionary

Special Report

Highlights A recovery in Chinese auto sales is not imminent. Car sales will likely stage only a rate-of-change improvement, moving from deep to mild contraction or stagnation over the next three-to-six months. Low-speed electric vehicles are a cheap substitute for regular low-end cars. Their production requires fewer inputs and parts compared to cars. Hence, their rising penetration will be negative for economic activity at the margin. Auto ownership will continue to rise in China in the years to come. However, this does not necessitate rising car sales. In fact, auto ownership can increase with car sales contracting in each consecutive year. This scenario represents a major risk to auto stock prices. Feature Chart 1Chinese Auto Sales: An Extended Downturn Chinese automobile sales have been deep under water for 15 consecutive months. The magnitude of the contraction has been even worse than the one that occurred in 2008-‘09. Annualized sales1 have declined from a peak of nearly 30 million units in June 2018 to 26 million this September (Chart 1). To put this 4-million-unit decline into perspective, only about 5 million units of automobiles were produced in Germany last year. Given the already long and deep contraction, does this mean Chinese auto sales and production are about to stage an imminent recovery? Although a revival sometime next year is plausible, we are not positive in the near term. Car sales will stage a rate-of-change improvement only, moving from deep to mild contraction or stagnation (i.e. zero growth) the next three to six months (Chart 1, bottom panel). Gauging The Demand Outlook Chart 2Marginal Propensity To Spend Is Falling Reluctance to purchase a car and curtailed financing are the causes of the deep auto sales contraction in China. The factors that have weighed on consumers’ willingness to purchase cars remain intact. First, our indicator for household marginal propensity to spend continues to fall, indicating no immediate signs of a turnaround (Chart 2). Cyclically, decelerating economic activity is weighing on income expectations, prompting consumers to delay their discretionary spending. Besides, the growth rate of disposable income per capita is at the lower end of its historical range and is falling in real (inflation-adjusted) terms (Chart 3). In addition, Chinese households are more leveraged now than their U.S. counterparts (Chart 4). Their debt levels have reached over 120% of annual disposable income. Chart 3Real Disposable Income Growth Is Weakening Chart 4Chinese Households Are Increasingly Indebted   Meanwhile, the U.S.-China confrontation continues to foster uncertainty among consumers and businesses in the Middle Kingdom. Although some sort of agreement was reached last week, the future of longer-term U.S.-China relations remains highly uncertain. Hence, the potential “phase-one” trade agreement is unlikely to shift Chinese consumers’ and businesses’ overall cautious sentiment. These factors will continue to weigh on consumers’ purchasing behavior, especially on big-ticket items like automobiles. Reluctance to purchase a car and curtailed financing are the causes of the deep auto sales contraction in China. Second, Chinese auto financing penetration rate – measured as the proportion of autos bought using borrowed funds – has risen from 20% in 2014 to about 48%2 last year. This remains well below the 70%-plus penetration rate in major western countries (the U.S., Germany and France), but is not far from the 50% rate in Japan. The rapid increase in the use of auto financing has facilitated auto sales in China over the past several years. Financing for auto purchases has been provided by banks via loans and credit cards, dealer/manufacturer loans and peer-to-peer lending (P2P). While banks contribute about 40% of auto financing and auto dealers/manufacturers account for about 30%, the peer-to-peer platform has become the third major source of auto loans in recent years. Chart 5Limited Auto Financing From Peer-To-Peer Platforms However, since early last year, bankruptcies and closures of P2P platforms have significantly reduced available auto financing. P2P financing continues to shrink, further depressing loans for auto purchases (Chart 5). Third, there is an ongoing structural decline in consumers’ willingness to purchase cars due to greater traffic congestion, limited parking and improved public transportation. In addition, greater use of ride-sharing and car-sharing services, which the government is aiming to promote, will also continue to reduce the need to buy a car. Concerning government incentives for auto buyers, auto sales have failed to recover, so far this year, despite policy support and significant auto price cuts (Box 1). Although the government recently loosened some restrictive auto sales policies in certain cities,3 the scale was much smaller than what was done earlier this year. As in any market, production decisions are driven by sales, not inventories. Box 1 Policy Support And Auto Price Cut During January-September 2019 Since late January, Chinese authorities have released a set of pro-auto-consumption measures aimed at spurring auto sales. These measures include the approval of 100,000 new license plates in Guangzhou province and an additional 80,000 in Shenzhen. Since May, auto dealers in China have slashed prices of their Emission Standard 5 cars in order to liquidate inventories, as 15 provinces/provincial level cities have been implementing the new emissions standards since July 1, 2019 – one year earlier than the national implementation deadline. According to the law, vehicles that do not meet the new standard will not be allowed to be sold or registered once the new standard is implemented. Another pertinent question to address is whether inventories can be used to identify a bottom in this industry. This is difficult to gauge in China, as inventories at different stages of the supply chain are currently sending conflicting signals. Manufacturers’ inventories have dropped to low levels (Chart 6). Yet, dealers’ inventories remain elevated according to the newly released inventory data for September (Chart 7). Chart 6Auto Manufacturers Inventories Are Low... Chart 7...But Dealers Inventories Remain Elevated   Chart 8Auto Demand Drives Production As in any market, production decisions are driven by sales, not inventories. The chain reaction always starts from demand: rising sales lead to rising production. Producers do not typically ramp up output when sales are falling, even if inventories are low (Chart 8). Without a strong and durable rise in demand, manufacturers will not significantly increase their inventories. In short, low car inventories among manufacturers could lead to a short-term rise in output. A sustainable and lasting recovery in production, however, is contingent on a cyclical revival in auto sales. Bottom Line: A cyclical recovery in auto sales is not imminent in the next three-to-six months. A Threat From A Cheap Substitute In many small cities (from Tier 3 to Tier 6 cities), towns and villages where auto buyers are more sensitive to prices, consumers are opting to purchase low-speed electric vehicles (LSEVs) – a cheap substitute for regular autos. Last year, LSEV makers sold about 1.5 million units in China, accounting for about 6% of passenger vehicle sales for the year. In comparison, even with massive government subsidies, total new energy vehicle (NEV, mainly including pure electric vehicles and plug-in hybrids) sales only reached 1.2 million units in 2018, 20% lower than LSEV sales. In many small cities, towns and villages consumers are opting to purchase low-speed electric vehicles (LSEVs) – a cheap substitute for regular autos. LSEVs are small, short-range electric vehicles (three- or four-wheeled cars) with top driving speeds below 80km per hour and with a similar look to regular cars.4 They have much lower technical and safety standards: LSEVs are not considered automobiles by the country’s motor vehicle management system. Consequently, official auto production and sales data released by authorities do not include LSEV figures. Chart 9Significant Output Expansion In Low-Speed Electric Vehicles Technically, these vehicles are within some sort of grey area of Chinese regulations, but that has not stopped the industry's remarkable growth. Shandong province accounts for about 40% of the country’s LSEV output. The dramatic LSEV production expansion in the province gives a glimpse into the booming LSEV industry in China (Chart 9). Last year’s LSEV production drop was due to the government’s tightening of LSEV output policies and greater competition from small-size pure electric vehicles, which benefited from government subsidies. Both factors have diminished this year due to policy changes and the termination of subsidies for the small-size pure electric vehicle. Looking forward, consumers will continue purchasing LSEVs as a substitute for lower-end cars. They will have negative effect on low-end car sales, especially when household budgets tighten. Table 1 lays out the main differences between an LSEV and a lower-end passenger car. Clearly, the most attractive feature of an LSEV is its price, which can be as cheap as 10,000 RMB (less than US$2,000) with a big proportion of LSEVs ranging from 20,000 RMB to 30,000 RMB. In comparison, prices of lower-end passenger vehicles in general range from 50,000RMB to 80,000 RMB, more expensive than LSEVs. As nearly half of Chinese households already own an automobile, the potential of future auto sales clearly lies in lower-income households. However, the 2018 NBS household survey showed the annual household disposable income for the lowest 60% percentile rural households was lower than the low-end price of regular auto – 50,000 RMB (US$ 7,050) (Chart 10). In comparison, a much cheaper LSEV will be affordable for them. Given that they are inferior goods, LSEVs could become even more attractive at times of weak disposable income growth. In addition to cheap prices, Box 2 reveals other attractive features that will make LSEVs the most convenient and affordable form of transportation for many potential auto buyers. This will also help promote the popularity of the LSEVs in small cities and rural areas. Table 1The Comparison Between LSEVs And Lower-End Passenger Cars Chart 10Low-Speed Electric Vehicles: Affordable For Lower-Income Households   Further, this year’s regulatory changes are also favorable for the LSEV industry (Box 3). This marked a clear policy reversal from last year when the government executed a crackdown on LSEV production and issued a policy prohibiting new capacity of LSEVs. Box 2 The Non-Price Reasons For The Increasing Popularity Of The LSEVs The LSEV is more convenient as it is easy to drive and to park because of its small size. The drive range of 100 km per charge of the battery is sufficient for a person who only uses it to go to work or pick up the kids from school. It is particularly useful in small cities and rural areas where the public transportation network is poor. The speed of 40-60 km per hour is also fast enough to drive in small cities and rural area where there are not much road traffic and the roads are often designed for low driving speed. LSEVs also have the benefit of being able to charge from home electrical outlets, eliminating the need to use public charging/fueling infrastructure. Box 3 Policy On LSEV Industry: More Favorable In 2019 Than In 2018 In March, the Ministry of Industry and Information Technology announced that by 2021 the national standards of the “Technical Conditions of Four-Wheel Low-Speed Electric Vehicles” would be established. This will eventually bring the LSEV market under the government’s supervision while giving LSEV makers two years to improve their technology. This will help improve the quality and safety measures of LSEVs. In May and June, over 20 cities started to issue car plates for LSEVs and approved of the LSEVs right to be on the road. This signals that the government is aiming to regulate the LSEV sector in a positive way, rather than simply banning production. Bottom Line: Cheap LSEVs will be a low-cost substitute for regular low-end cars. Their production requires fewer inputs and parts compared to cars. Hence, their rising penetration will be negative for economic activity at the margin. What About NEV Demand? New Electric Vehicle (NEV) sales were a bright spot among all categories of auto sales in China last year, with year-on-year growth of 62%. However, NEV sales growth has decelerated considerably this year as the government began cutting subsidies (Chart 11). NEV sales will remain under pressure. Table 2 shows the timeline of China’s NEV subsidy exit plan, which was released in late March. The subsidy is set to be phased out by 2021. Chart 11New Electric Vehicle Sales Growth Will Slow But Remain Positive Table 2The China’s New Electric Vehicle Subsidy Exit Plan   In comparison to last year, there will be no subsidy at all for pure electric vehicles (PEVs) with recharge mileage of 250 kilometers and lower. This will make it more difficult for mini-PEVs to compete with LSEVs with respect to price. For PEVs with recharge mileage of 250 kilometers and above, the subsidy has also been cut significantly. However, we still expect NEV demand growth to remain positive. The government will continue to maintain zero sales tax on NEVs until the end of 2020. This gives it a major advantage over non-NEV vehicles, which carry the 10% sales tax. In addition, NEVs are exempt from license restrictions on car sales and time or area restrictions on on-road autos, in cities where such policies apply. This is an attractive privilege for car buyers to consider. Current NEVs that can achieve recharge mileage of 300-450 kilometers, sell at a price of RMB 100,000 to RMB 150,000 per unit. They are both affordable and appealing for upper-middle-income and high-income urban households who prefer either green options or energy cost savings. The recharge mileage is sufficient for most daily use, and prices are in line with prices of traditional gasoline or diesel cars. If and as auto sales fail to stage a notable recovery in the next several months, Chinese auto stock  prices will likely break down. Bottom Line: With the gradual phasing out of subsidies, the period of exponential NEV sales growth is over. Nevertheless, NEV demand growth will likely remain positive. Investment Implications Chart 12Chinese Auto Stock Prices Could Break Down There are three pertinent investment implications to consider. First, Chinese auto stock prices in the domestic A-share market have dropped by 60% from their 2017 highs, and have lately been moving sideways (Chart 12). Notably, these listed automakers’ per-share earnings have plunged, and the companies have cut dividends by more than the drop in their share prices (Chart 13). As a result, their trailing P/E ratio has risen and the dividend yield has dropped (Chart 14). This implies that investors are looking through the current sales contraction and expecting an imminent recovery. Chart 13A Major Contraction In Corporate Earnings And Dividends Chart 14Rising Trailing P/E And Falling Dividend Yield   If and as auto sales fail to stage a notable recovery in the next several months, these share prices will likely break down. Second, petroleum demand growth from the transportation sector will be decelerating in China over the coming years. Rising NEV sales as a share of total auto sales, substituting autos for LSEVs and a slower pace of growth in the number of vehicles on roads imply diminishing demand for gasoline in the coming years (Chart 15). Today BCA’s Emerging Markets Strategy service is also publishing a Special Report discussing India’s demand for oil. The report argues for slowing growth in Indian oil demand. Combined, China and India make up 19% of the world’s oil consumption (slightly lower than the 21% accounted for by the U.S.), and weaker demand growth in these economies is negative for oil prices. Third, investors should differentiate between a long-term economic view and investment strategy. We do not disagree with the economic viewpoint that auto ownership will rise in China in the years to come. But this will happen even if auto sales decline on an annual basis over the next 10 years. Chart 16 illustrates this point: if annual auto sales drop by 2% during each consecutive year over the next decade, and the scrap rate is around 3%, car ownership, defined as the share of households owning one car, will continue to rise from the current 50% level, reaching 80% by 2030. Chart 15Falling Growth In Existing Vehicles Entails Slower Growth In Gasoline Demand Chart 16Stimulation: Car Ownership Can Rise With Shrinking Auto Sales   Nevertheless, such a scenario – a 2% annual drop in car sales in each consecutive year over the next decade - is bearish for automakers’ share prices. Any stock price is very sensitive to long-term growth expectations for corporate earnings.5 A 2% recurring annual drop in car sales will be disastrous for auto stock valuations. This is a case when the long-term economic view on rising prosperity and car ownership in China stands in contrast with a negative investment outcome for the auto sector and its shareholders. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1      Sales of total automobiles, including passenger vehicles and commercial vehicles. 2      From Chinese Banking Association Report on June 18, 2019. https://www.china-cba.net/Index/show/catid/14/id/26688.html 3      Guangzhou further added 10,000 car plates open to the public while Guiyang eliminated cap on new-vehicle sales. 4      https://www.wsj.com/video/big-in-china-tiny-electric-cars/CF7E986A-7C70-4EE3-8F7B-441621F10C94.html 5      The reason is that both interest rates and earnings long-term growth rate are present in the denominator of any cash flow discount model (Stock Price = Expected Dividends / (Interest rate – Earnings long-term growth rate)). Hence, they have the potential to affect share prices exponentially while dividends/profits are present in the numerator so their impact on equity prices is linear.

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 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. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights MARKET FORECASTS Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist   I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows     An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering   The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright   The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 10Who Will Win The 2020 Democratic Nomination? China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1  The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20).   Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future.   Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive Chart 35Is Value Turning The Corner?   Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36).     Chart 36BYields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38).  Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Chart 39Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit     Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Chart 48Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter.  A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity   The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1  Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter.  How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows:  Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China   Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Set a profit target of 11 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. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations 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

In late-summer 2010, we published a Special Report overviewing long-term U.S. equity sector relative performance during deflationary periods. Since then, inflation – core PCE deflator to be more specific – only briefly flirted with the Federal Reserve’s 2% target in mid-2018, while long-term inflation expectations never managed to re-anchor higher. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head. Pundits – us included – are still waiting for inflationary pressures to finally pass-through. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head (Chart 1). The late-2018 tightening in financial conditions will exert downward pressure on year-over-year CPI growth, albeit with a slight lag (top panel, Chart 1). More broadly, the ongoing deceleration in the U.S. economy, as evidenced by the sharp decline in the ISM manufacturing PMI (and most of its subcomponents), represents a serious headwind for inflation (second panel, Chart 1). Given weak global growth, the appreciating U.S. dollar – a countercyclical currency – will also weigh on inflation going forward (not shown). Further, we don’t view the recent perky inflation prints as sustainable. In fact, core goods CPI – which accounts for 25% of core CPI and has been the main driver lately – is expected to roll over and contract over the next 18 months (third panel, Chart 1). Chart 1Still Looking For Inflation? U.S. Equity Strategy’s corporate pricing power proxy has also sharply sunk corroborating that the path of least resistance is lower for core inflation (bottom panel, Chart 1). In other words, if Marty McFly could ride the DeLorean to travel back in time once more, he would certainly approve of deflation/disinflation being a major equity theme at BCA, and would even ask us to delve deeper into our prior analysis. That is precisely what we do in this Special Report. We acknowledge the current disinflationary trend and provide more details on the historical relative performance of the different equity sectors in such periods. We introduce a simple trading rule based on these deflationary episodes, which we define as two or more consecutive quarters of negative corporate sector price deflator growth (Chart 2). We treat single quarters of positive growth within broader deflationary trends as outliers, which translate into the occasional quarterly rebounds within the shaded areas. Chart 2Deflationary Periods The next pages provide some more color on the sectors historical relative performance. Notably, we add a brief overview of the annualized returns realized by heeding the signals from two consecutive quarters of negative corporate sector price deflator growth. Since 1960, there have been 27 such signals, with a median duration of 15 months and the shortest one being six months. As such, we feel comfortable using 6-, 12- and 24-month horizons to go long (short) the sectors we identified did well during deflationary (inflationary) periods, whenever signaled. Table 1 summarizes the results of this empirical exercise. Table 1 Sector Relative Performance And Deflation (From 1960 To Present) Our hypothesis during disinflationary periods is that defensives outshine cyclicals. The results for the GICS11 relative sector performance are consistent with our hypothesis. Specifically, following our deflationary signal, defensives are up 1.4% on a 6-month horizon, while cyclicals are down 2.5%. We also note an inflection point around the 12-month mark as cyclicals start to recover their losses moving from -2.5% to just -0.21%, while defensives are giving up their gains moving from 1.38% to 0.76%. This finding is consistent with the median deflation period duration of 15 months, as highlighted earlier. Similarly, if we look 24 months out, we observe that cyclicals are outperforming the market by 0.5% (largely driven by tech), and defensives are lagging the market by -1.2% (dragged by telecom and utilities) signaling that the market has recovered. Diagram 1Performance Time Line Importantly, we are currently in a deflationary environment as defined by our two-quarter signal that commenced mid-2018, and U.S. Equity Strategy has been actively reducing cyclical exposure over the past six months and highlighting that investors should be cautious on the prospects of the broad equity market. Turning back to Table 1, we also see some divergences in the GICS1 sector performance vs. some of our expectations. Utilities should outperform during disinflation periods, owing to two factors: (1) steady cash flow growth, (2) falling interest rates boost the allure of high yielding competing assets. Another notable outlier is the S&P consumer discretionary index. Specifically, the roughly 2% underperformance in the six months following our deflationary signal took us by surprise, as discretionary spending should at the margin get a boost from declining interest rates. To conclude, we also present a time line that summarizes results from Table 1 as well as the sector specific comments. Importantly, the time line is a road map that should be only used “as a rule of thumb” guide to navigate a deflationary environment. Keep in mind, that even though the median duration for a deflationary period is 15 months, it can still last anywhere from just under a year to over four years. As always, context is key. Finally, stay tuned for an update on our traditional U.S. equity sector profit margin outlook report that is due in the upcoming months. What follows are additional details of our analysis on a per sector basis, along with charts on sector specific pricing power and revenue turnover.     Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com   Consumer Staples (Overweight) The S&P consumer staples index performs well during deflationary periods. Likely explanatory variables are the safe haven status of this index along with an ongoing industry consolidation. Our sector pricing power proxy reveals that staples have not experienced a contraction in pricing power since 2003. While relative share prices are staging a recovery, they are still one standard deviation below the historical time trend. Further gains are likely given impressive returns on a 6-, 12-, and 24-month time horizon following our deflationary signal. We remain overweight the S&P consumer staples index. Energy (Overweight) Among the cyclical sectors, S&P energy is the second largest underperformer, declining 3.4% on average in relative terms in the six months following our deflationary signal. The underperformance is also evident in our PP proxy. Energy companies’ PP declines right as the economy enters deflation, which is consistent with our expectations, as oil plays a key role in virtually any inflation/deflation measure. One caveat at the current juncture is the recent oil price spike that may serve as a catalyst to unlock excellent value in bombed out energy equities. As a result of the drone attacks on Saudi Arabia’s production and refining facilities we expect geopolitical premia to get built into crude oil prices on a sustained basis. We are currently overweight the S&P energy index. Health Care (Overweight) During deflationary periods the S&P health care sector has outperformed the broad market, similar to its defensive sibling, the S&P consumer staples sector. On top of the safe haven nature of the health care industry, pricing power has never crossed below the zero line during the entire history of the data series. This remarkable feat also applies to the sector’s sales growth. We are currently overweight the S&P health care index. Industrials (Overweight) On the eve of deflation, industrials equities start wrestling with two opposing forces: cheapened raw materials versus slowing economic activity. In the end, economic softness wins the tug-of-war as this deep cyclical index underperforms the market on 6-, 12- and 24-month time horizon by -1.4%, -1.0% and -0.5%, respectively. The sector’s pricing power usually displays a sharp decline as we enter a deflationary zone weighing on industrials revenue prospects and thus relative performance. We are currently overweight the S&P industrials sector. Financials (Overweight) Being an early cyclical sector, it is not surprising that the S&P financials sector tends to underperform the broad market on 6-, 12- and 24-month horizon following our two-quarter deflation signal. The largest underperformance for financials comes late into the deflationary period. In fact, had we excluded utilities from our analysis, the S&P financials sector would have been the worst performing sector across the board on a 12- and 24-month time horizon. The heavyweight banks subgroup accounting for roughly 42% of the S&P financials market capitalization weight explains the underperformance. As a reminder banks underperform when the price of credit is falling owing to deflation/disinflation. Given that our fixed income strategists expect a selloff in the bond market, we remain overweight the S&P financials index. Technology (Neutral – Downgrade Alert) Back in 2010, we reiterated that tech equities were deflationary winners, a fact that has not changed since then. The frenetic pace of innovation in and of itself, has prepared the sector to cope with episodes of deflation. Within cyclicals, technology is by far the best performing sector in our Table 1, but the present-day geopolitical and trade tensions compel us to be neutral on the sector with a potential downgrade coming down the line via a software subgroup downgrade. Tech pricing power is resilient during deflationary episodes. However, tech sales growth, which appears to have peaked for the cycle, swings violently, warning of potential turbulence ahead if a down oscillation is looming. We are neutral the S&P technology sector, which is also on our downgrade watch list. Telecommunication Services (Neutral) Traditionally defensive telecom services stocks have been struggling recently, saddled with rising debt, fighting to remain relevant and avoid becoming a “dumb pipe”. The industry’s pricing power proxy also highlights the point as telecom companies never managed to regain their footing since the GFC. Another important point is that the index materially underperforms the market across all the time horizons we examined returning: -1.5%, -2.0% and -4.4%. Our hypothesis was that telecom carriers should outperform during deflationary periods owing to stable cash flow growth generation and a high dividend yield profile. But, empirical evidence shows the opposite. Likely, the four decades-long sustained underperformance of this now niche safe haven industry suggests that sector specific dynamics are at fault. We are currently neutral the S&P telecommunication services index. Materials (Underweight) Despite the massive demand from China and, more generally, from the EM complex for commodities over the past several years, the S&P materials sector never actually managed to break free from its structural downtrend. The sector is one of the major disinflationary losers as evident from the chart. Importantly, since the mid-70s, most of the periods when materials managed to outperform the broad market occurred outside the shaded areas and recessions. On average, materials sector pricing power also tends to decline sharply when global growth weakens, as is currently the case. And, with a slight delay, materials sector revenue growth will likely suffer a setback, warning that revenue growth has crested for the cycle. We reiterate our recent downgrade of the S&P materials sector to underweight. Consumer Discretionary (Underweight – Upgrade Alert) Contrary to our hypothesis, S&P consumer discretionary stocks underperform during disinflationary periods that weigh on interest rates. Likely decelerating economic activity trumps that fall in interest rates and consumers gravitate toward staple goods and services and away from discretionarfy purchases. Table 1 reveals that consumer discretionary stocks actually suffer the most early in a deflationary period (-2.0%), and then sharply recover 12 months out and turn marginally positive (0.1%). We are currently underweight the S&P consumer discretionary index, but have it on upgrade alert as a potential buying opportunity. Utilities (Underweight) As for the final sector of this Special Report, we had highlighted that the S&P utilities is a notable outlier in our analysis as it does not behave according to our expectations. Likely, some industry specific dynamics are at play as high-yielding safe haven utilities stocks severely underperform during deflationary periods. The sector returns -3.5%, -4.3%, and -4.5% versus the broad marekt on a 6-, 12, and 24-month time horizon, respectively. In theory, two factors should have pushed the relative share price higher: (1) steady cash flow growth and (2) falling interest rates, both of which boost the allure of high yielding competing assets. Neither one was sufficient to break away from the structural downtrend that has been haunting the sector over the years. We are currently underweight the S&P utilites index.   Footnotes 1    We are using GICS 2 Telecommunication Services index instead of the parent GICS 1 Communication Services index due to the lack of data as the index was only recently introduced.

Energy Stocks Are Heading North Banks Clamoring For Higher Rates And A More Hawkish Fed Homebuilding Stocks Are Catching Up To Housing Starts Will Global Trade Get “Fed-Exed”? Do Not Try To Bottom Fish… ... In Cyclicals Vs. Defensives​​​​​​​

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Underweight The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (second panel). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. Labor-related input costs are also on fire as the sector’s wage inflation is climbing at a 3.9%/ annum pace or roughly 120 bps higher that the overall business sector employment cost index (bottom panel). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel). Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. Please see our most recent Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH.