Economy

Highlights Duration: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. TIPS: We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. High-Yield: Investors should add (or increase) exposure to the high-yield energy sector, within an overweight allocation to junk bonds. Junk energy spreads are attractive, and exposure to the sector will mitigate the impact of a potential oil supply shock. Feature Only a month ago, investors were becoming more optimistic about a global growth rebound and the US/China phase 1 trade deal was pushing political risk into the background. Both of those factors caused the 10-year Treasury yield to rise throughout December, hitting an intra-day Christmas Eve peak of 1.95% (Chart 1). But since then, softer global PMI data and the US/Iranian military conflict brought global growth concerns and political risk back to the fore, breaking the uptrend in yields. Chart 1Bond Bear On Pause Global growth and political uncertainty are two of the five macro factors that we identify as important for US bond yields.1 And despite the recent setback, we think both factors will push yields higher in the coming months. Global Growth We have found that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index are the three global growth indicators that correlate most strongly with US bond yields. One reason for the recent pullback in yields is the disappointing December data from the Global and US Manufacturing PMIs. The ISM Manufacturing PMI moved deeper into recessionary territory. The Global Manufacturing PMI had been in a clear uptrend since mid-2019, but fell back to 50.1 in December, from 50.3 the month before (Chart 2). The US and Chinese PMIs also declined in December, though they remain well above the 50 boom/bust line (Chart 2, panels 3 & 4). The Eurozone and Japanese PMIs, meanwhile, are still in the doldrums (Chart 2, panels 2 & 5). More worrying than the small tick down in Global PMI is the US ISM Manufacturing PMI moving deeper into recessionary territory, from 48.1 to 47.2. However, we have good reason to think that stronger data are just around the corner (Chart 3). Chart 2Global PMI Ticks Down Chart 3ISM Manufacturing Index Will Rebound First, the difference between the new orders and inventories components of the ISM index often leads the overall index at turning points, 2016 being a prime example (Chart 3, top panel). Much like in 2016, a gap is opening up between new orders-less-inventories and the overall ISM. Second, the non-manufacturing ISM index remains strong despite the weakness in manufacturing (Chart 3, panel 2). With no contagion to the service sector of the economy, we’d expect manufacturing to pick back up. Third, the ISM Manufacturing index has diverged sharply from the Markit Manufacturing PMI, with the Markit index printing well above the ISM (Chart 3, panel 3).2 The ISM index has been more volatile than the Markit index in recent years, and should trend toward the Markit index over time. Fourth, regional Fed manufacturing surveys have generally been stronger than the ISM during the past few months. A simple regression model of the ISM index based on data from regional Fed surveys suggests that the ISM index should be at 49.7 today, instead of 47.2 (Chart 3, bottom panel). Finally, unlike the PMI surveys, the CRB Raw Industrials index has increased quite sharply in recent weeks (Chart 4). We should note that it is not the CRB index itself but rather the ratio between the CRB index and gold that tracks bond yields most closely, and this ratio has actually declined lately due to the strength in gold. Nonetheless, a sustained turnaround in the CRB index would mark a big change from 2019 and would send a strong bond-bearish signal. Chart 4CRB Sends A Bond-Bearish Signal Political Uncertainty The second factor that sent bond yields lower during the past few weeks was the military conflict between the US and Iran. Tensions appear to have de-escalated for now, and we would expect any flight-to-quality flows to unwind during the next few weeks.3 But while we see policy uncertainty easing in the near-term, sending bond yields higher, we reiterate our view that US political uncertainty is the number one risk factor that could derail the 2020 bear market in bonds.4 Specifically, we see two looming US political risks. The first relates to President Trump’s re-election odds. For now, Trump’s approval rating is in line with past incumbent presidents that have won re-election (Chart 5). But if his approval doesn’t keep pace in the coming months, he will try to do something to change his fortunes. That could mean re-igniting the trade war with China, or once again ramping up tensions with Iran. A Bernie Sanders or Elizabeth Warren victory would send a flight-to-quality into bonds. The second risk is that one of the progressive candidates – Bernie Sanders or Elizabeth Warren – secures the Democratic nomination for president. Right now, both trail Joe Biden in the polls and betting markets (Chart 6), but things could change rapidly as the primary results come in during the next few months. The stock market would certainly sell off if an Elizabeth Warren or Bernie Sanders presidency seems likely, sending a flight to quality into bonds.5 Chart 5Trump’s Approval Rating Must Rise Chart 6Democratic Nomination Betting Odds Bottom Line: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. Playing An Oil Supply Shock In US Bond Markets US/Iranian military tensions are easing for now, but could flare again in the future. For that reason, it’s worth considering how US bond markets would respond in the event of a conflict between the US and Iran that removed a significant amount of the world’s oil supply from the market, causing the oil price to spike. The first implication is that US bond yields would fall. Even though it’s tempting to say that the inflationary impact of higher oil prices would push yields up, this effect would not dominate the flight-to-quality into US bonds that would result from the increase in political uncertainty. Case in point, Chart 1 shows that, while the inflation component of yields was stable as tensions flared during the past few weeks, it didn’t come close to offsetting the drop in the 10-year real yield. Beyond the impact on Treasury yields, there are two other segments of the US bond market that would be materially impacted by an oil supply shock: the TIPS breakeven inflation curve and corporate bond spreads. Buy TIPS Breakeven Curve Flatteners Table 1CPI Swap Curve Sensitivity To Oil When considering the impact of an oil supply shock on TIPS breakeven inflation rates, we first look at how the cost of inflation protection is influenced by changes in the oil price. Table 1 shows the sensitivity of weekly changes in different CPI swap rates to a $1 increase in the price of Brent crude oil. We use CPI swap rates instead of TIPS breakeven inflation rates because data are available for a wider maturity spectrum. Our analysis applies equally to the TIPS breakeven inflation curve. Two conclusions are apparent from Table 1. First, the entire CPI swap curve is positively correlated with the oil price, a higher oil price moves CPI swap rates higher and vice-versa. Second, the sensitivity of CPI swap rates to the oil price is greater at the short-end of the curve than at the long-end. This is fairly intuitive given that higher oil prices are inflationary in the short-term but could be deflationary in the long-run if they hamper economic growth. Chart 7Coefficients Stable Over Time Chart 7 shows that our two main conclusions are not dependent on the chosen time horizon. The 2-year CPI swap rate is positively correlated with the oil price for our entire sample period, as is the 10-year rate except for a brief window in 2014. The 2-year rate’s sensitivity is also consistently higher than the 10-year’s. Based on this analysis, we can suggest two good ways to hedge against the risk of an oil supply shock that sends prices higher: Buy inflation protection, either in the CPI swaps market or by going long TIPS versus duration-equivalent nominal Treasuries. Buy CPI swap curve (or TIPS breakeven inflation curve) flatteners.6 But we can introduce one more wrinkle to our analysis. Oil prices can rise because of stronger demand or because a shock suddenly removes supply from the market. It’s possible that the cost of inflation protection behaves differently in each case. Fortunately, the New York Fed has made an attempt to distinguish between those two scenarios. In its weekly Oil Price Dynamics Report, the Fed decomposes Brent oil price changes into demand-driven changes and supply-driven changes.7 It does this by looking at how other financial assets respond to oil price changes each week. Chart 8 shows the cumulative change in the Brent oil price since 2010, along with the New York Fed’s supply and demand factors. According to the Fed, demand has pressured the oil price higher since 2010, but this has been more than offset by greater supply. Chart 8Supply & Demand Oil Price Decomposition Using the New York Fed’s supply and demand series, we look at how CPI swap rates respond to higher oil prices in three different scenarios. First, we identify 252 weeks when demand and supply both contributed to higher oil prices. Second, we identify 95 weeks when higher oil prices were driven solely by demand. Finally, and most pertinently, we identify 92 weeks when higher oil prices were driven only by supply (Table 2). Table 2Weekly Change In CPI Swap Rate When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios are consistent with our results from Table 1. CPI swap rates across the entire curve move higher more than half the time, with greater increases at the short-end of the curve. However, the scenario we are most interested in is the ‘Supply Driven’ scenario. Presumably, a military conflict with Iran that took oil supply off the market would lead to less supply and also a decrease in global demand. Results for this scenario are more mixed. The 1-year CPI swap rate still rises 60% of the time, but rates further out the curve are somewhat more likely to fall. With this in mind, CPI swap curve or TIPS breakeven curve flatteners look like the best way to hedge against an oil supply shock, better than an outright long position in inflation protection. This is good news, since we have previously argued that owning TIPS breakeven curve flatteners is a good idea even without an oil supply shock.8 Corporate bond excess returns respond positively to changes in the oil price. We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. Buy Energy Junk Bonds Table 3Corporate Bond Sensitivity To Oil Corporate bonds are the second segment of the US fixed income market that could be materially impacted by an oil supply shock, particularly bonds in the energy sector. To assess the potential value of corporate bonds as a hedge, we repeat the above analysis but use weekly corporate bond excess returns versus duration-matched Treasuries instead of CPI swap rates. Table 3 shows that investment grade and high-yield corporate bond returns both respond positively to changes in the oil price. Further, we see that energy bonds are more sensitive to the oil price, outperforming the overall index when the oil price rises, and vice-versa. Chart 9 shows that, while oil price sensitivities vary considerably over time, they are almost always positive. Also, energy sector sensitivity has been consistently above that of the benchmark index since 2014. Chart 9Betas Mostly Positive Going one step further, we once again use the New York Fed’s supply and demand decomposition to identify weeks when supply and/or demand was responsible for higher oil prices. Because we have more historical data for corporate bonds than for CPI swaps, this time we identify 340 weeks when both supply and demand drove the oil price higher, 123 weeks when only demand drove it higher and 142 weeks when only supply was responsible for the higher oil price (Table 4). Table 4Weekly Corporate Bond Excess Returns (BPs) When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios show that higher oil prices boost excess returns to both investment grade and high-yield corporate bonds more than half the time. Energy bonds also tend to outperform their respective benchmark indexes in the ‘Demand & Supply Driven’ scenario, but perform roughly in-line with the benchmark in the ‘Demand Driven’ scenario. But once again, it is the ‘Supply Driven’ scenario that we are most interested in. Here, we see that an oil supply disruption that leads to higher oil prices also leads to lower corporate bond excess returns. This is true for both the investment grade and high-yield indexes and for energy bonds in both rating categories. However, we also note that high-yield energy debt significantly outperforms the overall junk index during these “risk off” periods. In contrast, investment grade energy debt is not a clear outperformer. Chart 10HY Energy Spreads Are Very Attractive These results line up with our intuition. When oil prices are driven higher by demand it could simply be a sign of strong economic growth and not any specific trend related to the energy sector. As such, we’d expect all corporate bonds to perform well in those scenarios, but wouldn’t necessarily expect energy debt to outperform. However, supply disruptions in the Middle East directly benefit US shale oil players, whose debt is principally found in the high-yield energy sector. The investment grade energy sector is less exposed to the US shale space, and its documented outperformance in the ‘Supply Driven’ scenario is weaker as a result. We already recommend an overweight allocation to high-yield bonds and a neutral allocation to investment grade corporates. Within that overweight allocation to high-yield bonds, we recommend shifting some exposure toward the energy sector for two reasons. First, high-yield energy was severely beaten-down last year and is ripe for a rebound if global economic growth recovers, as we expect (Chart 10). Second, our analysis suggests that an allocation to energy will help mitigate losses in the event of a renewed flaring of US/Iranian tensions that removes oil supply from the market. Bottom Line: We recommend that investors initiate TIPS breakeven curve flatteners (or CPI swap curve flatteners) and add exposure to the high-yield energy sector. Both positions look attractive on their own terms, but will also help hedge the risk of an oil supply disruption if US/Iranian tensions flare back up in the months ahead.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The others are: the output gap, the US dollar and sentiment. For more details please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 The Markit index is used in the construction of the Global PMI shown in Chart 2, 3 For more details on the politics behind the US/Iran conflict please see Geopolitical Strategy Special Alert, “A Reprieve Amid The Bull Market In Iran Tensions”, dated January 8, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets”, dated September 13, 2019, available at gis.bcaresearch.com 6 In the TIPS market, an example of a breakeven curve flattener would be to buy 2-year TIPS and short the 2-year nominal Treasury note, while also buying the 10-year nominal Treasury note and shorting the 10-year TIPS. 7 https://www.newyorkfed.org/research/policy/oil_price_dynamics_report 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Gold bullion is on the move again, and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data, all signal that it no longer pays to be bearish materials stocks. Augment exposure to neutral. Recent Changes Boost global gold miners to overweight via the long GDX/short ACWI exchange traded funds, today. Book gains and lift the S&P materials sector to neutral, today.  Table 1Sector Performance Returns (%) Feature “There is nothing so disturbing to one's well-being and judgment as to see a friend get rich.” - Charles P. Kindleberger “The bubble involves the purchase of an asset, usually real estate or a security, not because of the rate of return on the investment but in anticipation that the asset or security can be sold to someone else at an even higher price; the term the ‘greater fool’ has been used to suggest the last buyer was always counting on finding someone else to whom the stock or the condo apartment or the baseball cards could be sold.”  - Charles P. Kindleberger Equities broke out to fresh all-time highs in the second week of the year, shrugging off the flare up in geopolitical risk. It seems that nothing can derail this juggernaut and the following narrative is now prevalent: Bad news is actually good for equities because the Fed will step in and do more QE and cut interest rates anew. Good news is great because the Fed will not hike interest rates as the economy is chugging along. No news is good news as money has to flow somewhere and equities are the default answer. Kindleberger’s quotes above are instructive.      To put the recent advance in perspective, the SPX is up 425 points uninterruptedly since early October – when the Fed commenced ramping up its Treasury purchases – and it is, at a minimum, headed for a much needed breather. Contrary to popular belief, a handful of tech stocks explain this recent meteoric rise rather than a broad-based advance (Chart 1). Currently, the top five stocks in the S&P 500 (AAPL, MSFT, GOOGL, AMZN & FB) comprise over 18% of its market cap, even higher than the late-1999/early-2000 concentration (top panel, Chart 1). On January 9, 2020, AAPL’s $30bn one day market cap increase was larger than the bottom 300 stocks’ market cap in the S&P 500 and is another anecdote that drives this return concentration point home.   Chart 1Teflon Tech Stocks   As a reminder, we are neutral the broad tech sector and overweight the largest subgroup, the S&P software index, thus participating in this euphoric rise in stocks that has been defying earnings fundamentals. Granted, such phenomena are prevalent late cycle. While this can go on for a bit longer, it is clearly unsustainable and represents a big risk especially given the proliferation of passive funds. Tack on rising geopolitical risks and the odds of a sharp drawdown increase significantly. Before we proceed to our SPX EPS analysis, however, it is worth noting some disappointing economic data. The decade low in the ISM manufacturing, the deceleration in non-farm payroll growth, the grinding higher in the 4-week average of unemployment insurance claims, the contraction in C&I loans, the sustained pessimism in CEO confidence and the down hook in average hourly earnings all warn that macro headwinds abound despite the looming signing of the “phase one” US/China trade deal (Chart 2). All of the rise in the SPX last year was due to multiple expansion. Now, in order for the SPX to continue rallying, profits will have to do the heavy lifting. However, our analysis shows that the market is fully priced and earnings will have to hit escape velocity in order for equities to grow into their pricey valuations (Chart 3). Chart 2Underwhelming Chart 3Lofty Valuations Currently, our SPX EPS growth model has no pulse. This four-factor macro model is regression based (out of sample since January 2014) and continues to forecast a contraction into mid-year (Chart 4). Chart 4No EPS Pulse Table 2 summarizes three EPS scenarios analysis, along with a forward P/E multiple and SPX forecast. Table 2Three Scenarios This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. Step 1: We plugged into the model our base, worse and best case estimates of these four variables into mid-year, and we got as output the model’s estimate of EPS growth for end-2020 with a range of -1% to 10% (one important assumption is that the historical correlation of the movement of these variables holds steady). Step 2: Then, we applied these growth rates to the IBES 2019 EPS forecast of $162/share and arrived at our end-2020 three scenarios EPS level estimates with a range of $160/share to $178/share. Step 3: We then assigned probabilities to those three outcomes resulting in an EPS forecast of $169/share. Step 4: In order to get an SPX expected value we needed to assign a forward P/E multiple to our EPS estimate. Thus, we introduced our base, worse and best case forward P/Es (with an equal probability of occurrence) and multiplied them with our $169/share weighted EPS forecast in order to arrive at the SPX 3,049 expected value for end-2020 (please refer to the Appendix below for additional details of our analysis and click here if you would like to request the excel file and insert your own estimates and probabilities). Chart 5 depicts the results of our analysis. Chart 5Projections Currently, sell-side analysts expect 10% profit growth in calendar 2020, a tall order in our view, and the SPX appears 8% overvalued according to our analysis. However, a potential break in historical correlations where the ISM recovers, the bond market sells off fearing an inflationary spurt pushing interest rates higher yet P/E multiples continue to expand indiscriminately, could sustain the melt-up phase in stocks in general and mega cap tech stocks in particular. While the macro data cannot fall indefinitely and a natural trough will occur sometime in the first half of the year, we doubt that a V-shaped recovery is imminent. Our base case is a stabilization of macro data equating to roughly 5% EPS growth for this year as noted above, with risks clearly titled to the downside. Under such a backdrop, perceptive equities will have to, at least, mildly deflate to this EPS reality. This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. In Gold We Trust While the SPX has been on an impressive run, it has failed to outshine gold bullion that has been on a tear lately. The bottom panel of Chart 6 shows that gold could be sniffing out a couple of Fed interest rate cuts, warning that the economic backdrop remains frail. This gold move is compelling us to reintroduce a modest portfolio hedge and today we recommend augmenting exposure to global gold miners to overweight. Chart 6What Is Gold Sniffing Out? Global gold miners have a lot going for them. Rising global policy uncertainty plays to their strength as investors seek the refuge of safe haven assets especially when geopolitical risks flare up (top panel, Chart 7). If our FX strategists hit the bull’s eye and the greenback loses steam this year,1 then gold related equities should outperform given the inverse correlation most commodities, including bullion, enjoy with the US dollar (bottom panel, Chart 7). Chart 7Solid Backdrop Importantly, real US bond yields have taken a beating recently underpinning gold prices and gold mining equities. This is significant, as bullion yields nothing and gold miners next to nothing so from an opportunity cost perspective it pays to hold a zero yielding asset when competing yields fall and vice versa (second panel, Chart 7). Worrisomely, this fall in real US yields is de facto pushing global real yields lower, which might indicate that investors worry that the global economy has more downside. In fact, economists’ estimates for GDP growth (as compiled by Bloomberg, third panel, Chart 7) continue to decelerate globally, and they forecast below-trend real output growth in the US for 2020. Global manufacturing also reflects this soft economic backdrop. While the global manufacturing PMI is trying to trough – it ticked down last month and is just a hair above the boom/bust line – both its momentum and diffusion are weak, heralding a catch up phase in global gold miners (PMI momentum shown inverted, Chart 8). Chart 8Global Economy Not Out Of The Woods Yet Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. From a gold positioning perspective, on all three fronts we monitor (gold ETF holdings, gold net speculative positions and bullish consensus on gold) we see green lights (Chart 9). Even global gold miners’ extremely overbought positions have now been worked out according to our Technical Indicator (TI). Following the parabolic bull run from May to September last year, our TI is now drifting to the neutral zone. Relative valuations have also corrected offering investors a compelling entry point (Chart 10). Chart 9Enticing Sentiment Chart 10Compelling Entry Levels In sum, gold bullion is on the move again and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Bottom Line: Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. Lift Materials To Neutral While materials stocks have broken down recently, our fresh gold miners overweight lifts the broad materials sector from previously underweight to currently neutral (Chart 11). Not only have relative share prices given way, but also breadth is weak as measured both by the percentage of groups with a positive year-over-year momentum and by the number of groups trading above their 40-week moving average (Chart 12). Moreover, relative valuations are downbeat (second panel, Chart 12), with relative P/S and P/B cratering. Chart 11Breakdown On the profit front, earnings breadth fell below neutral recently and net earnings revisions have collapsed. Wall Street analysts are even forecasting a dire relative revenue backdrop for the coming twelve months (Chart 13). Chart 12Washout Chart 13Extreme Pessimism Reigns While the sell-side has all but given up on this niche deep cyclical sector, we are going against the grain and posit that it no longer pays to be bearish materials stocks. First, our materials sector profit growth model has troughed and signals that a turnaround in EPS growth is underway and should gain steam this year (second panel, Chart 14). Keep in mind that this niche deep cyclical sector has borne the brunt of the Sino/American trade war and the recent de-escalation can serve as a catalyst for an earnings-led recovery (trade policy uncertainty shown inverted, Chart 11). Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation. Second, this industry is not at a standstill. Contrary to the overall economy, materials executives are investing in new projects as financial market reported materials sector capex clearly shows (third & bottom panels, Chart 14). These investments should bear fruit in coming quarters and translate into higher top line growth, something that is not at all discounted in bombed out relative sales growth expectations (bottom panel, Chart 13). Finally, there is tentative evidence that the EMs in general and China in particular are at least stabilizing. Not only are their manufacturing PMIs above the boom/bust line (not shown), but also financial market data suggest that the selling in materials stocks is nearing exhaustion. JP Morgan’s EM currency index is ticking higher, the CRB metals index is showing some signs of life and EM equities have been outperforming their global peers (Chart 15). Chart 14EPS Model Trough, Rising Capex…   Chart 15…And Firming Financial Market Data Signal It No Longer Pays To Be Bearish Netting it all out, washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data all signal that it no longer pays to be bearish materials stocks. Bottom Line: Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Appendix Appendix 1 Appendix 2 footnotes 1     Please see BCA Foreign Exchange Strategy Weekly Report, “On Oil, Growth And The Dollar” dated January 10, 2020, available at fes.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights The balance of power in US labor negotiations has shifted infrequently in the industrial age: Management completely dominated labor before the New Deal, which gave rise to a 45-year labor golden age that lasted until the Reagan revolution and globalization put employers firmly back in control. Employees rarely make gains without sympathetic elected officials and judges: The New Deal was a watershed in labor relations history because it granted workers legal protections that leveled the playing field with employers. Successful strikes beget strikes: Momentum matters in labor negotiations. One union’s win may embolden other unions to strike, blazing a path for further gains by demonstrating that the price of labor peace has risen. The pendulum may be swinging back in labor’s favor: Unions still face formidable headwinds in Washington, DC and state capitals, but a run of successful strikes may signal that rumors of the labor movement's demise have been exaggerated. Feature Where will inflation come from, and when will it arrive? An investor who answers these questions will have advance notice of the end of the expansion and the bull markets in equities and credit. Per our base-case scenario, the expansion won’t end until monetary policy settings become restrictive, and the Fed won’t pursue restrictive policy unless inflation pressures force its hand. Inured by a decade of specious warnings that “money printing” would let the inflation genie out of the bottle, investors are skeptical that inflation will ever re-emerge. The inflation backdrop has become much more supportive in the last few years, however, upon the closing of the output gap, and the stimulus-driven jolt in aggregate demand. Output gaps in other major economies will have to narrow further (Chart 1) for global goods inflation to gain traction, and mild inflation elsewhere in the G7 (Chart 2) suggests that goods prices are not about to surge. Chart 1There's Still Enough Spare Capacity ... Chart 2... To Restrain Global Goods Inflation Services are not so easily imported, though, and services inflation is a more fully domestic phenomenon. Rising wages could be the spur for services inflation, and the labor market is tight on several counts: the unemployment rate is at a 50-year low; the broader definition of unemployment, also encompassing discouraged workers and the underemployed, reached a new all-time (25-year) low in December; the JOLTS job openings and quits rates at or near their all-time (19-year) highs; and the NFIB survey and a profusion of anecdotal reports suggest that employers are having a hard time finding quality candidates. With labor demand exceeding supply, wages for nonsupervisory workers have duly risen (Chart 3). Gains in other compensation series have been muted, however, and investors have come to yawn and roll their eyes at any mention of the Phillips Curve. Chart 3Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Perhaps it’s not the Phillips Curve that’s broken, but workers’ spirits. A supine organized labor movement could explain why the Phillips Curve itself is so flat. As the old saying goes, if you don’t ask, you know what you’re going to get, and beleaguered unions and their memberships, cowed by two decades of woe coinciding with China’s entry into the WTO (Chart 4), have been afraid to ask. Strikes are the most potent weapon in labor’s arsenal; if it can’t credibly wield them, it is sure to be steamrolled. Chart 4Globalization Has Been Unkind To Labor Two years of high-profile strike victories by public- and private-sector employees may suggest that the sands have begun to shift, however, and inspired our examination of labor’s muscle. This first installment of a multi-part Special Report focuses on the history of US labor relations, with an eye toward identifying themes that shape relative bargaining power. We will subsequently examine the factors influencing the propensity for labor and management militancy, with a focus on where wages are headed in the near future. The Colosseum Era (1800-1933) We view US industrial labor history as having three distinct phases. We label the first, which lasted until the New Dealers took over Washington, the Colosseum era (Figure 1), because labor and management were about as evenly matched as the Christians and the lions in ancient Rome. Uprisings in textile mills, steel factories, and mines were swiftly squelched, often violently. Management was able to draw on public resources like the police and state National Guard units to put down strikes, or was able to unleash its own security or ad hoc militia forces on strikers or union organizers without state interference. The public, staunchly opposed to anarchists and Communists, generally sided with employers. Figure 1Significant Events In The Colosseum Era Unions won some small-bore victories during the period, but they nearly all proved fleeting as companies regularly took back concessions and public officials and courts failed to enforce the loose patchwork of laws aimed at ameliorating industrial workers’ plight. Labor inevitably suffered the brunt of the casualties when conflicts turned violent. Workers were hardly choir boys, and seem to have initiated violence as often as employers’ proxies, but they were inevitably outgunned, especially when police, guardsmen or soldiers were marshaled against them. Societal norms have changed dramatically since the Colosseum era, but the lore of past “battles” encourages an us-versus-them union mentality that occasionally colors negotiations. The UAW Era (1933-1981) Established presumptions about the employer-employee relationship were upended when FDR entered the White House. Viewing labor organization as a way to ease national suffering, New Dealers passed the Wagner Act to grant private-sector workers unionization and collective bargaining rights, and created the National Labor Relations Board to ensure that employers respected them. The Wagner Act greatly aided labor organization, enabling unions to build up the heft to engage with employers on an equal footing. Unionized workers still fought an uphill battle in the wake of the Depression, but tactics like the sit-down strike (Box) produced some early labor victories that paved the way for more. The UAW signed a similar accord with Chrysler immediately after the Flint sit-down strike, and the CIO (the UAW’s parent union) swiftly reached an agreement with US Steel that significantly improved steelworkers’ pay and hours. Labor unions’ path wasn’t always smooth – Ford fiercely resisted unionization until 1941, and ten protesters were killed, and dozens injured, by Chicago police at a peaceful Memorial Day demonstration in support of strikers against the regional steelmakers that did not follow US Steel’s conciliatory lead – but it generally trended upward after the New Deal (Figure 2). From the 1950 signing of the Treaty of Detroit, a remarkably generous five-year agreement between the UAW and the Big Three automakers, the UAW ran roughshod over the US auto industry for three-plus decades. The New Deal’s encouragement of unionization had given labor a fighting chance, and was the foundation on which all of its subsequent gains were built. Figure 2Significant Events In The UAW Era Box David Topples Goliath: The Flint Sit-Down Strike The broad mass of factory workers had not been organized to any meaningful degree before the New Deal, and the United Auto Workers (UAW) was not formed until 1935. Despite federal protections, the fledgling UAW had to conduct its operations covertly, lest its members face employer reprisals. At the end of 1936, when it took on GM, only one in seven GM employees was a dues-paying member. The strike began the night of December 30th when workers in two of GM’s Flint auto body plants sat down at their posts, ignoring orders to return to work. The sit-down action was more effective than a conventional strike because it prevented GM from simply replacing the workers with strikebreakers. It also made GM think twice about attempting to remove them by force, lest valuable equipment be damaged. GM was unsure how to dislodge the workers after a court injunction it obtained on January 2nd went nowhere once the UAW publicized that the presiding judge held today’s equivalent of $4 million in GM shares. It turned off the heat in one of the plants on January 11th, before police armed with tear gas and riot guns stormed it. The police were rebuffed by strikers who threw bottles, rocks, and car parts from the plant’s upper windows while spraying torrents of water from its fire hoses. No one died in the melee, but the strike was already front-page news across the country, and the attack helped the strikers win public sympathy. Michigan’s governor responded by calling out the National Guard to prevent a rematch, shielding the strikers from any further violence. The strike was finally settled on February 11th when GM accepted the UAW as the workers’ exclusive bargaining agent and agreed not to hinder its attempts to organize its work force. The Reagan-Thatcher Era (1981 - ??) The disastrous strike by the air traffic controllers’ union (PATCO) is the watershed event that heralded the end of unions’ golden age. Strikes by federal employees were illegal, so PATCO broke the law when it went on strike in April 1981, spurning the generous contract terms its leaders had negotiated with the Reagan administration. PATCO had periodically held the flow of air traffic hostage throughout the seventies to extract concessions from its employer, earning the lasting enmity of airlines, government officials and the public. Other unions were aghast at PATCO’s openly contemptuous attitude, and declined to support it with sympathy strikes, while conservatives blasted the new administration behind closed doors for the profligacy of its initial PATCO offer. President Reagan therefore had an unfettered opportunity to make an example out of the controllers, and he seized it, firing those who failed to return to work within 48 hours and banning them from ever returning to government employment. A fed-up public supported the president’s hard line, and employers and unions got the message that a new sheriff was in town. His deputies were not inclined to enforce labor-friendly statues, or investigate labor grievances, with much vigor, and they would not necessarily look the other way when public sector unions illegally struck. Unions also found themselves on the wrong side of the growing disaffection with bureaucracy that was bound up with the push for deregulation. The globalization wave further eroded labor’s power. Unskilled workers in the developed world would be hammered by the flat world that allowed people, capital and information to hopscotch around the globe. Eight years of a Democratic presidency brought no relief, as the “Third Way” Clinton administration embraced the free-market tide (Chart 5), and the unionized share of employees has receded all the way back to mid-thirties levels (Chart 6). Chart 5Inequality Took Off ... Chart 6... As Unions Lost Their Way A Fourth Phase? A handful of data points do not make a trend, especially in a series that stands out for its persistence, but the bargaining power pendulum could be shifting. Public school teachers won improbable statewide victories with illegal strikes in three highly conservative states in the first half of 2018 (Table 1); a canny hotel workers union steered its members to big gains in their contract negotiations with Marriott in the second half of 2018; and the UAW bested General Motors and the rest of the Big Three automakers last fall. Unions may have more bargaining power than markets and employers realize, and they could be on the cusp of becoming more aggressive in flexing it. The next installment(s) in this series will examine the factors determining whether or not unions will become more assertive and the likelihood that more assertive bargaining would meet with success. Table 1Teachers' Unions Conquer The Red States Takeaways There is not sufficient space to explore those factors in this installment, but we conclude by highlighting two key themes that emerge from our historical review. US industrial history makes it clear that employees are unlikely to gain ground if government sides with employers. Employees no longer have to fear that the state will look the other way while strikers are beaten, or fail to prosecute those responsible for loss of life, but they face especially long odds when the government is inclined to favor employers. Its thumb weighs heavily on the scale when it drags its feet on enforcement; cuts funding to agencies policing workplace standards; and appoints agency or department heads that are conditioned to see things solely from employers’ perspective, shaped by long careers in management. Successful strikes beget strikes, and the converse is also true. Withholding their labor is employees’ most powerful weapon, and when employers can’t replace them cheaply and easily, strikes often succeed. Striking is frightening for an individual, however, because it cuts off his or her income (or sharply reduces it, if the striker’s union has a strike fund) until the strike is over. If the strike fails, the employee may find him/herself blacklisted, impairing his/her long-term income prospects on top of his/her short-term losses. Prudent workers should therefore strike sparingly, with the due consideration that a prudent poker player exercises before going all-in. When other unions facing comparable conditions pull off successful strikes, it makes it much easier for another union to take the leap, in addition to making success more likely, provided conditions truly are comparable. “Before they occur, successful strikes appear impossible. Afterward, they seem almost inevitable .”1 The retrospective inevitability stiffens the spine of potential strikers who observe successful outcomes, and raises the bar for action among potential strikers who observe failures. “Just as defeats in struggle lead to demoralization and resignation, victories tend to beget more victories .”2 Public opinion matters just as surely as momentum, and it proved decisive in the Flint sit-down strike and in the air traffic controllers’ showdown with President Reagan. According to Gallup’s annual poll, Americans now regard unions as favorably as they did before Thatcher and Reagan came to power (Chart 7). We will dive more deeply into the topic in our next installment, as we probe labor market conditions for insight into the direction of inflation, and its implications for Fed policy, the business cycle and markets. Chart 7Could Unions Make A Comeback?   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics, Verso: New York (2019), p. 204. 2 Ibid, p. 209.

Highlights Global Investment Strategy View Matrix Receding trade tensions; diminished risks of a hard Brexit; reduced odds of a victory for Elizabeth Warren in the US presidential elections; liquidity injections by most major central banks; and improved sentiment about the state of the global economy all helped push stocks higher late last year. Some clouds have formed over the outlook since the start of the year, however. The December US ISM manufacturing index fell to the lowest level since 2009, while the PMIs in the euro area, UK, and Japan gave up some of their November gains. The conflict between the US and Iran also flared up. Although tensions have abated in recent days, BCA’s geopolitical strategists worry that the détente may not last. The US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. They argue that this could create a dangerous power vacuum in the Middle East. Stock market sentiment is quite bullish at the moment, which makes equities more vulnerable to any disappointing news. While we are maintaining our positive 12-month view on global equities and high-yield credit in anticipation that global growth will rebound convincingly later this year, we are downgrading our tactical 3-month view to neutral. Ho Ho Ho After handing investors a sack of coal last Christmas, Santa was back to his true self this past holiday season. Global equities rose 3.4% in December, finishing the year off with a stellar fourth quarter which saw the MSCI All-Country World index surge by 8.6%. Five forces helped push stocks higher: 1) Receding trade tensions; 2) Diminished risks of a hard Brexit; 3) Reduced odds of a victory for Elizabeth Warren in the US presidential elections; 4) Liquidity injections by the Fed, ECB, and the People’s Bank of China; and arguably most importantly 5) Improved sentiment about the state of the global economy. Tarrified No More Trade tensions subsided sharply after China and the US reached a “Phase One” agreement. The deal prevented tariffs from rising on December 15th on $160 billion of Chinese imports. It also rolls back the tariff rate from 15% to 7.5% on about $120 billion in imports that have been subject to levies since September (Chart 1). Chart 1The Evolution Of The US-China Trade War In addition, the Trump Administration allowed the November 13th deadline on European auto tariffs to lapse. This suggests that the US is unlikely to impose tariffs under the Section 232 investigation of auto imports. The auto sector has been at the forefront of the global manufacturing slowdown, so any good news for that industry is welcome. To top it all off, the US House of Representatives ratified the USMCA, the successor to NAFTA, on December 19th. We expect it to be signed into law in the first quarter of this year. Brexit Risks Fading... Chart 2The Majority Of British Voters Aren't Keen On Brexit Boris Johnson’s commanding victory in the UK elections has given him the votes necessary to push a withdrawal bill through parliament by the end of the month. The British government will then seek to negotiate a free trade agreement by the end of the year. A “no-deal” Brexit is unacceptable to the majority of British voters (Chart 2). As such, the Johnson government will have no choice but to strike a deal with the EU. ... While Trump Gains On the other side of the Atlantic, President Trump’s re-election prospects improved late last year despite (and perhaps because of) the ongoing impeachment process. There is an uncanny correlation between the probability that betting markets assign to a Trump victory and the value of the S&P 500 (Chart 3). Chart 3An Uncanny Correlation Chart 4Who Will Win The 2020 Democratic Nomination? It certainly has not hurt market sentiment that Elizabeth Warren’s poll numbers have been dropping recently (Chart 4). Warren’s best hope was to squeeze out Bernie Sanders as soon as possible, thereby leaving the far-left populist lane all to herself. That dream appears to have been dashed, which suggests that even if Trump loses, a centrist like Joe Biden could emerge as president. An Uneasy Truce It remains to be seen how President Trump’s decision to assassinate General Qassem Soleimani, a top Iranian commander, will affect the election outcome. A YouGov/HuffPost poll taken over the weekend revealed that 43% of Americans approved of the airstrike against Soleimani compared to 38% that disapproved.1 History suggests that the public’s patience for war will quickly wear thin if it results in American casualties or significantly higher gasoline prices. Neither side has an incentive to allow the conflict to spiral out of control. Foreign minister Mohammad Javad Zarif tweeted on Tuesday shortly after Iran lobbed missiles at two US military bases that Iran had “concluded” its retaliatory strike, adding that “We do not seek escalation or war.” Despite claims on Iranian public television that 80 “American terrorists” were killed in the attacks, no US troops were harmed. This suggests that the Iranians may be putting on a show for domestic consumption. The US economy is less vulnerable to spikes in oil prices than in the past. Nevertheless, plenty of things could still go wrong. BCA’s geopolitical team, led by Matt Gertken, has argued that the US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. This could create a dangerous power vacuum in the Middle East. There is also a risk that President Trump overplays his hand. Contrary to the President’s claims, Soleimani was quite popular in Iran (Chart 5). If Trump begins to mock the Iranian leadership’s feeble response, Iran will have no choice but to take more aggressive action. Chart 5Soleimani Was More Popular In Iran Than Trump Claims Chart 6US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past One thing that could embolden Trump is that the US economy is less vulnerable to spikes in oil prices than in the past. US oil output reached as high as 12.9 mm b/d in 2019, allowing the country to become a net exporter of oil for the first time in history (Chart 6). Any increase in oil prices would incentivize further domestic production, which would help bring prices back down. The US economy has also become less energy intensive – it takes less than half as much oil to produce a unit of GDP today than it did in the early 1980s. Finally, unlike in the past, the Fed will not need to raise rates in response to higher oil prices due to the fact that inflation expectations are currently well anchored. In fact, as we discuss below, we expect the Fed and other central banks to continue to provide a tailwind for growth over the course of 2020. The Fed’s “It’s Not QE” QE Program The jump in overnight lending rates in mid-September torpedoed the Federal Reserve’s efforts to shrink its balance sheet. Thanks to a steady stream of Treasury bill purchases since then, the Fed’s asset holdings have swelled by over $400 billion, reversing more than half of the decline observed since early 2018 (Chart 7). Chart 7Fed's Asset Holdings Are Growing Anew Chart 8The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed has insisted that its latest intervention does not amount to a new QE program, stressing that it is buying short-term securities rather than long-dated bonds. In so doing, it is simply creating bank reserves, rather than seeking to suppress the term premium by altering the maturity structure of the private sector’s holdings of government debt. Nevertheless, even such straightforward interventions have proven to be powerful signaling tools. By growing its balance sheet, a central bank is implicitly promising to keep monetary policy very accommodative. It is worth remembering that the run-up in the NASDAQ in 1999 coincided with a significant balance-sheet expansion by the Fed in response to Y2K fears, which came on the heels of three “insurance cuts” in 1998 (Chart 8). Gentle Jay Paves The Way Chart 9Inflation Expectations Remain Muted In 2000, the Fed moved quickly to reverse the liquidity injection it had orchestrated the prior year. We do not expect such a reversal anytime soon. Moreover, unlike in 2000, when the Federal Reserve kept raising rates – ultimately bringing the Fed funds rate up to 6.5% in May 2000 – the Fed is likely to stay on hold this year. The Fed’s ongoing strategic policy review is poised to move the central bank even closer towards explicitly adopting an average inflation target of 2% over the course of a business cycle. Since inflation tends to fall during recessions, this implies that the Fed will seek to target an inflation rate somewhat higher than 2% during expansions. Realized core PCE inflation has averaged only 1.6% since the recession ended. Both market-based and survey-based measures of long-term inflation expectations remain downbeat (Chart 9). This suggests that the bar for raising rates this year is quite high. More Monetary Easing In The Euro Area And China Chart 10Chinese Monetary Easing Should Help Global Growth Bottom Out The ECB resumed its QE program in November after a 10-month hiatus. While the current pace of €20 billion in monthly asset purchases is well below the prior pace of €80 billion, the central bank did say it would continue buying assets for “as long as necessary” to bring inflation up to its target. The language harkens back to Mario Draghi’s 2012 “whatever it takes” pledge, this time applied to the ECB’s inflation mandate. Not to be outdone, the People’s Bank of China cut the reserve requirement ratio by 50 basis points last week, a move that will release RMB 800 billion ($US 115 billion) of fresh liquidity into the banking system. Historically, cuts in reserve requirements have led to faster credit growth and ultimately, to stronger economic growth both in China and abroad (Chart 10). The PBOC has also instructed lenders to adopt the Loan Prime Rate (LPR) as the new benchmark lending rate. The LPR currently sits 20bps below the old benchmark rate (Chart 11). Hence, the PBOC’s order amounts to a stealth rate cut. Our China strategists expect further reductions in the LPR over the next six months. In addition, the crackdown on shadow bank lending seems to be subsiding, which bodes well for overall credit growth later this year (Chart 12). Chart 11China: Stealth Monetary Easing Chart 12Crackdown On Shadow Banking In China Is Easing   Rising Economic Confidence Chart 13Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Chart 14The Wider Public Was Also Worried About A Downturn   At the start of 2019, nearly half of US CFOs thought the economy would be in a recession by the end of the year. Similarly, two-thirds of European CFOs and four-fifths of Canadian CFOs expected their respective economies to succumb to recession. Professional economists were equally dire (Chart 13). Households also became increasingly worried about a downturn. Google searches for “recession” spiked to near 2009-highs last summer (Chart 14). The mood has certainly improved since then. According to the latest Duke CFO survey, optimism about the economic outlook has increased. More importantly, CFO optimism about the prospects for their own firms has risen to the highest level in the 18-year history of the survey (Chart 15). Chart 15CFOs Have Become More Optimistic Of Late Show Me The Money Going forward, global growth needs to accelerate in order to validate the improved confidence of CFOs and investors alike. We think that it will, thanks to the lagged effects from the easing in financial conditions in 2019, a turn in the global inventory cycle, a de-escalation in the trade war, easier fiscal policy in the UK and euro area, and re-upped fiscal/credit stimulus in China. For now, however, the economic data remains mixed. On the positive side, household spending is still robust across most of the world, a fact that has been reflected in the resilience of service-sector PMIs (Chart 16). Chart 16AThe Service Sector Has Remained Resilient (I) Chart 16BThe Service Sector Has Remained Resilient (II) Chart 17US Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Chart 18US Housing Backdrop Is Solid The US consumer, in particular, is showing little signs of fatigue. The Atlanta Fed GDPNow estimates that real personal consumption grew by 2.4% in the fourth quarter, having increased at an average annualized pace of 3% in the first three quarters of 2019. Both a strong labor market and housing market have buoyed US consumption. Payrolls have risen by an average of 200K per month for the past six months, double what is necessary to keep up with labor force growth. This week’s strong ADP release – which featured a 29K jump in jobs in goods-producing industries in December, the best since April – suggests that today’s jobs report will remain healthy. In addition, wage growth has picked up, particularly at the bottom of the income distribution (Chart 17). Residential construction has also been strong. Homebuilder sentiment reached the best level since June 1999 (Chart 18). Global Manufacturing: Too Early To Call The All-Clear The outlook for manufacturing remains the biggest question mark in the global economy. The US ISM manufacturing index dropped to 47.2 in December, its lowest level since June 2009. The composition of the report was poor, with the new orders-to-inventory ratio dropping close to recent lows. Chart 19Other US Manufacturing Gauges Are Not As Weak As The ISM We would discount the ISM report to some extent. The regional Fed manufacturing indices have not been nearly as disappointing as the ISM (Chart 19). The Markit PMI, which tracks US manufacturing activity better than the ISM, clocked in at a respectable 52.4 in December, down only slightly from November’s reading of 52.6. Nevertheless, it is hard to be excited about the near-term outlook for US manufacturing, especially in light of Boeing’s decision to suspend production of the 737 Max temporarily. Most estimates suggest that the production halt will reduce real US GDP growth by 0.3%-to-0.5% in the first quarter. The euro area manufacturing PMI gave up some of its November gains, falling to 46.3 in December. While the index is still above its September low of 45.7, it has been under 50 for 11 straight months now. The UK and Japanese PMI also retreated. Chinese manufacturing has shown clearer signs of bottoming out. Despite dipping in December, the private sector Caixin manufacturing PMI remains near its 2017 highs. The official PMI published by the National Bureau of Statistics is less upbeat, but still managed to come in slightly above 50 in December. The production subcomponent reached the highest level since August 2018. Reflecting the positive trend in the Chinese economy, Korean exports to China rose by 3.3% in December, the first positive growth rate in 14 months (Chart 20). Taiwan’s exports have also rebounded. The manufacturing PMI rose above 50 in both economies in December. In Taiwan’s case, this was the first time the PMI moved into expansionary territory since September 2018. On balance, we continue to expect global manufacturing to recover in 2020. This is in line with our observation that global manufacturing cycles typically last three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 21). That said, the weakness in European and US manufacturing (at least judged by the ISM) is likely to give investors pause. Chart 20Some Positive Signs Emerging From Korea And Taiwan Chart 21A Fairly Regular Three-Year Manufacturing Cycle   Investment Conclusions We turned bullish on stocks in late 2018, having temporarily moved to the sidelines during the summer of that year. Global equities have gained 25% since our upgrade. We see another 10% of upside for 2020, led by European and EM bourses. Despite its recent gains, the real value of the MSCI All-Country World Index is only 3% above its prior peak in January 2018. The 12-month forward PE ratio of 16.3 is still somewhat lower than it was back then. The valuation picture is even more enticing if we compare equity earnings yields with bond yields, which is tantamount to computing a rough equity risk premium (ERP). The global ERP remains quite high by historic standards, especially outside the US where earnings yields are higher and bond yields are generally lower (Chart 22). Chart 22The Equity Risk Premium Is Fairly High, Especially Outside The US Chart 23Stock Market Sentiment Is Quite Bullish   Nevertheless, sentiment is quite positive towards stocks at the moment (Chart 23). Elevated bullish sentiment, against the backdrop of ongoing uncertainty about the outlook for global manufacturing and an uneasy truce between the US and Iran, poses a near-term headwind to risk assets. As such, while we are maintaining our positive 12-month view on global equities and high-yield credit, we are downgrading our tactical 3-month view to neutral for the time being. We do not regard this as a major realignment of our views; we will turn tactically bullish again if stocks dip about 5% from current levels.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Ariel Edwards-Levy, “Here's What Americans Think About Trump's Iran Policy,” TheHuffingtonPost.com (January 6, 2020).   MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades

Highlights An analysis on Indonesia is available below. We intend to maintain our long EM stocks position, initiated on December 19, as long as the MSCI EM equity index does not break below our stop point of 6% below current levels. Global trade will improve on a rate-of-change basis. Nevertheless, both money and bank asset impulses in China have already rolled over, and the credit impulse could relapse in the first half of 2020. As a result, the staying power of China’s recovery remains doubtful. For now, we continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Feature Chart I-1Investors Are Very Bullish On US Stocks EM share prices and currencies are at a crossroads. On one hand, some green shoots have recently emerged in Asia’s business cycle. On the other hand, global stocks are overbought and investor sentiment is very bullish, as evidenced by the record large net long position held by asset managers and leveraged funds in US equity indices futures (Chart I-1). The clash between these forces will define trading in EM risk assets in the coming weeks. If EM share prices and currencies consolidate their recent gains without a major relapse, it will signal that a sustainable rally lies ahead. Alternatively, if EM stocks and exchange rates drop considerably, it will indicate that improving investor sentiment and flows (technicals) rather than a durable recovery in corporate profitability (fundamentals) are what produced the recent rebound. We initiated a long position in EM stocks on December 19 and intend to maintain it unless the MSCI EM equity index breaks below our stop point of 1050, which is 6% below current levels. Green Shoots In Asia There are a number of green shoots beginning to emerge in Asia. December data point to a budding recovery in Asia’s business cycle: manufacturing PMIs rose in December in Korea, Taiwan and Singapore (Chart I-2). The measure was flattish in China and slightly down in Japan (Chart I-2, bottom two panels). Korean exports have begun recovering on a rate-of-change basis (Chart I-3, top panel). What’s more, the average of new and backlog orders rose for Chinese NBS and Taiwanese manufacturing PMIs in the past couple of months (Chart I-3, middle and bottom panels). Chart I-2Green Shoots In Asia Chart I-3Asian Exports To Improve On A Rate-Of-Change Basis   Chart I-4DRAM And NAND Prices Have Improved Post December 15 Finally, following the announcement of the US-China phase one trade deal on December 13, semiconductor NAND and DRAM prices rose (Chart I-4). It seems that the phase one trade deal has boosted sentiment not only among investors worldwide but also among business executives in Asia. Even though US ISM and European PMI manufacturing data remain lackluster, we continue to emphasize that what matters for – and is an indication of – EM growth is China’s and emerging Asia’s manufacturing cycles. In a nutshell, we put much more weight on Asian rather than DM manufacturing data when gauging trends in EM stocks and currencies. The marginal improvement in Asian manufacturing provides veracity to the recent rally in EM equities and currencies. Chart I-5China: Credit And Fiscal Versus Broad Money Impulses China’s credit and fiscal impulse continues to point up (Chart I-5, top panel), also supporting the notion that global trade will be improving on a rate-of-change basis. In addition, we have entered the second year of the global trade/manufacturing contraction, and the base effects are much more benign – Asian exports started shrinking in late 2018. Hence, odds are that global trade will be contracting at a reduced pace from a year ago, and by mid-2020 may even post slightly positive growth. Looking beyond the near term, however, the Chinese money and bank asset impulses have already rolled over (Chart I-5, middle and bottom panels). Given that they have often led the credit and fiscal spending impulse, odds are that the latter will roll over in the coming months. If this is indeed the case, the improvement in China’s growth will be short-lived. What does it all mean? Investors should play this EM rally with tight stop points. The near-term growth outlook is benign, but the sustainability of this recovery is not yet assured. Having rebounded in recent months, EM financial markets could soon start looking through the current improvement in economic conditions in China and could become preoccupied with its growth outlook in the second half of 2020. Market Signals Are Mixed Apart from China’s money and credit impulses, we are watching numerous market signals to corroborate or reject the hypothesis of a durable recovery in both China’s business cycle and global trade. Several of these market signals have not yet confirmed this hypothesis. Chinese and Korean government bond yields have drifted lower in recent weeks, a phenomenon that is typically associated with weakening growth in China and global trade (Chart I-6). Apart from semiconductor stocks, global cyclical sectors have not outperformed the global equity index. Specifically, global industrials, materials, autos, as well as freight and logistics, have been flat to down versus the global aggregate stock index (Chart I-7). Chart I-6Yellow Flags From Bond Yields In China And Korea Chart I-7Global Cyclicals Have Not Outperformed Yet Chart I-8No Breakout In Industrial Metals Prices Industrial metals in general – and copper prices in particular – have not yet broken out (Chart I-8). Correspondingly, the broad trade-weighted US dollar has corrected sharply but has not yet broken down. So far, the greenback’s retrenchment is more consistent with a correction rather than a bear market. A breakout in industrial metals prices and a breakdown in the broad trade-weighted dollar would confirm that China’s growth and global trade have entered a period of lasting expansion. Finally, our Risk-On/Safe-Haven currency ratio1 has so far been inconclusive. This ratio strongly correlates with the EM equity index (Chart I-9). Barring a major breakout in this indicator, the medium- and long-term outlook for EM stocks will remain opaque. Chart I-9Cyclical Versus Safe-Haven Currencies And EM Stocks Bottom Line: While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. In the coming weeks, price actions in EM financial markets will reveal if EM stocks and currencies have entered a genuine and lasting bull market or if their recent rebound has been driven by euphoria surrounding the US-China trade deal. Asset Allocation: EM Versus DM We recommended buying EM stocks on December 19 but we stopped short of outright upgrading EM versus DM stocks. We are seeking confirmation from the market signals listed above before upgrading our allocation to EM within a global equity portfolio from underweight to overweight. While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. First, EM per-share earnings (EPS) continue to underperform DM EPS in both local and common currency terms (Chart I-10). So long as EM EPS lag DM peers, EM equities, currencies and credit markets will trail their DM counterparts. Second, growth woes in EM are not limited to China or global trade. Domestic demand in many EM economies outside China, Korea and Taiwan continues to slump (Chart I-11, top and middle panel). Besides, core inflation has fallen to a record low, dampening corporate profits (Chart I-11, bottom panel). Chart I-10EM EPS Continues To Lag DM Chart I-11EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak Chart I-12EM Ex-China, Korea And Taiwan: Need Lower Lending Rates Even though EM central banks have reduced interest rates, in many economies lending rates in real, inflation-adjusted terms have risen rather than declined (Chart I-12). The basis is that inflation has dropped more than lending rates. High lending rates explain why credit demand is poor. In a nutshell, many EM economies require much more easing to recover. Third, EM equity valuations are not more attractive than DM ones. While EM stocks are cheaper compared to their US counterparts, they are more expensive versus euro area equities. Overall, EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts (Chart I-13). In short, there is no strong valuation case for favoring EM versus DM. Finally, we have been speculating since March 2019 that the absolute and relative performance of EM stocks is more likely to resemble their profiles in 2011-14 rather than in 2016-17. This thesis has so far been playing out. Chart I-14 illustrates an overlay of share prices in EM and DM as well as EM’s relative equity performance to DM. The overlay compares the period from 2017 to present with the one from 2011-14. Chart I-13EM Equities Command Neutral Valuations Chart I-14EM And DM Stocks Are Tracking Their 2012 Profiles   DM share prices rallied substantially in 2011-14 but EM equities, currencies and credit markets as well as commodities prices have been flat to down. As a result, EM massively underperformed DM during that global bull market (Chart I-14, bottom panel). EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts. That occurred because EM domestic fundamentals were poor back in 2011-14 and China’s growth stabilized but failed to stage a meaningful recovery (please refer to the bottom panel of Chart I-2 on page 2). Bottom Line: We continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Review Of Some Of Our Open Positions We are closing the following strategic position: short EM equities / long US 30-year Treasurys. In the past 10 years, US bonds have done much better than EM equities on a total return basis in common currency terms (Chart I-15). This position had been profitable till October but our gains have evaporated since then and we are closing it flat. We are booking a 8.3% gain on long Asian / short US semiconductor stocks, a position initiated on June 13, 2019. Asian semis stocks have already rallied a lot and potential weakness in the US dollar will help US semis while cap upside in Asian semis stocks. We are reiterating the long gold / short oil and copper trade recommended on July 11, 2019 (Chart I-16). In any feasible global macro scenario, gold will continue outperforming oil and copper. The basis is that global real interest rates will stay low. Chart I-15Close Short EM Equities / Long US 30-Year Treasurys Position Chart I-16Stay With Long Gold / Short Oil And Copper Trade   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Struggling Under High Real Rates Indonesian commercial banks have been the only leg holding up the Indonesian stock market (Chart II-1). However, their cyclical outlook is uninspiring as their share prices risk selling off. The critical issue is that lending rates in the Indonesian economy are too high for borrowers. Hence, banks are facing a lose-lose dilemma: Either bank lending rates will have to drop, squeezing Indonesian commercial banks’ net interest rate margins, or non-performing loans (NPL) will mushroom as debtors cannot afford such high borrowing costs. In both cases, bank profits will suffer. Both of these scenarios are bearish for commercial banks’ share prices. Given that banks account for 47% of the overall MSCI Indonesia stock market capitalization and the rest of the equity market has been struggling due to worsening corporate profitability, the outlook for this bourse is downbeat. We continue recommending underweighting Indonesian stocks within an EM equity portfolio. The Indonesian economy is facing strong deflationary pressures. Both headline and core consumer price inflation have dropped to the bottom of the central bank’s inflation target band (Chart II-2, top panel). Meanwhile, corporate pricing power as measured by the GDP deflator has weakened significantly (Chart II-2, bottom panel). Chart II-1Indonesia: Financials Are The Only Sector Rallying Chart II-2Indonesia: Inflation Is Undershooting   Disinflationary forces have caused the nation’s nominal GDP growth to plummet dangerously below bank lending rates (Chart II-3). This makes it more difficult for borrowers to service their debt and will ensure rising NPL in the banking system. Crucially, it also discourages new credit demand. The top panel of Chart II-4 shows that bank loan growth is decelerating. Chart II-3Borrowing Costs Are Excessive Chart II-4Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates     Although the central bank has cut its policy rate by 100 basis points in 2019, bank lending rates dropped by only 17 basis points and currently stand at 10.2% in nominal terms (Chart II-4, middle panel). In real (inflation-adjusted) terms, bank lending rates remain very elevated (Chart II-4, bottom panel). Consistent with excessive borrowing costs, both the consumer and business sectors are struggling: Retail sales (excluding vehicles) volume growth is hovering around zero (Chart II-5, top panel). Retail sales of specific items are contracting (Chart II-5, middle panel). Meanwhile, motorcycle and car unit sales are shrinking (Chart II-5, bottom panel). Industrial activity is also lackluster. Freight traffic is very weak, capital goods imports are contracting and domestic cement consumption remains anemic (Chart II-6). Consistently, EBITDA of non-financial publically-listed companies is flirting with contraction (Chart II-7). Chart II-5A Major Deceleration In The Consumer Sector Chart II-6Indonesia: Industrial Activity Is Subdued   Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. The government is focused on keeping the budget deficit in check and no major fiscal stimulus should be expected. Therefore, monetary policy/lower interest rates should be the only source of stimulus. Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. With rate cuts by the central bank failing to translate into much lower bank lending rates, the sole viable option for authorities is to force commercial banks to reduce their lending rates. This strategy appears to be already in place, as demonstrated by President Joko Widodo’s November speech where he explicitly encouraged commercial banks to lower their lending rates. Such moral suasion or regulatory push by the authorities will likely intensify in the coming months. Doing so, however, will squeeze commercial banks’ net interest rate margins and hit banks’ profits (Chart II-8). Alternatively, if banks refuse to drop their lending rates meaningfully, their NPL will proliferate, damaging their profits.  Chart II-7Indonesia: Corporate Profits Are About To Contract Chart II-8Commercial Banks' Net Interest Margins Will Fall   Importantly, Indonesian commercial banks are expensive with a PBV ratio of 2.7; therefore, banks’ share prices will be extremely sensitive to negative news regarding their profit growth outlook. Investment Recommendations Chart II-9Indonesian Stocks Relative To The EM Equity Benchmark Equity investors should continue underweighting this bourse. Chart II-9 shows that relative equity performance versus EM is teetering. Our short position in the rupiah versus the US dollar remains in place but we are instituting a stop point at 13500 USD/IDR to manage risks. The basis for rupiah depreciation is as follows: In an economy that is facing unbearable high real borrowing costs and no willingness or ability to stimulate fiscally, the currency will likely serve as an adjustment valve. It will probably depreciate to boost exports and encourage import substitution as well as generate inflation. Critically, when the economy is stumbling due to excessive real interest rates, the latter do not typically engineer currency appreciation. In fact, the currency tends to depreciate rather than appreciate in cases when the return on capital is below borrowing costs. Indonesia fits this profile very well. Consistent with our expectations for currency depreciation, we continue underweighting Indonesian domestic bonds and sovereign credit within their respective EM benchmarks. We will alter this stance if our stop on the rupiah is triggered. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1    Average of CAD, AUD, NZD, BRL, MXN, RUB, CLP & ZAR total return indices relative to average OF JPY & CHF total return indices. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations