Economy

Highlights Global Growth: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. New Zealand: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades. Feature Investors have a lot of information to process at the moment. The daily ebb and flow of headlines on the US-China trade negotiations remains the biggest source of intraday volatility. Yet there are also mixed signals coming from economic data releases. “Soft” survey data like global manufacturing PMIs are showing some improvement, while “hard” measures of economic activity like export volumes and capital goods orders continue to languish in both the developed and emerging economies. As we have discussed in recent reports, these sorts of cross-currents are typical at cyclical inflection points. “Hard” data is reported with a lag after “soft” data, making the latter a better indicator of future economic activity than exports or fixed investment data (or even GDP data) that can be several months old once reported, reducing their market-moving relevance. The indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. When global growth is in the process of bottoming, as appears to be the case now, leading economic indicators are more reliable guides to follow for investment decision-making. To that end, the indicators that we trust the most are sending a bullish message on growth – and a bearish message for government bonds. The Latest From Our Global LEI & Global ZEW Chart of the WeekMore Cyclical Upward Pressure On Bond Yields We received updates on two of our most reliable indicators – our global leading economic indicator (LEI) and the global ZEW expectations index – last week. Both showed broad-based improvement, highlighting that the sharp downward momentum in global growth seen over the past year is in the process of bottoming out. The global LEI and the global ZEW index are key inputs into our Duration Indicator, which has historically led developed market bond yields by between six and nine months (Chart of the Week). The Duration Indicator bottomed back in January of this year and, right on cue, the yield on the Bloomberg Barclays Global Treasury Index has gone up 28bps from the low seen on September 3. The improvement in our global LEI is also broad based. The diffusion index (i.e. the share of countries with a rising LEI) shows that around 75% of the countries in the global LEI are experiencing improved economic activity. Importantly, that share is consistent across both the developed market (DM) and emerging market (EM) nations in the indicator, heralding a synchronized improvement in global growth. (Chart 2).   In absolute level terms, however, the EM sub-component of our global LEI has shown the most dramatic improvement over the past several months, compared to the DM sub-index that is only in the process of bottoming out. The EM index is boosted by improvements in large economies like China and Mexico – countries that have seen significant easing of monetary policy and financial conditions over the past 6-9 months. At the same time, the lagging performance of the DM component of our global LEI is consistent with the more subdued signals to date from the individual DM country data. The US LEI continues to drift lower, while the LEIs within the euro area for Germany, Italy and (most notably) France have all been moving higher (Chart 3). Even the Japan and UK LEIs have picked up a bit, although both remain at only moderate levels. At the same time, the expectations components of the individual country ZEW surveys have all begun to increase (bottom panel), despite more mixed performance within the current conditions components of the same ZEW survey (top panel). Chart 2Our Global LEI Continues to Climb, Led By EM Chart 3A Mixed Bag Of DM Growth Indicators Without a doubt, a reduction of US-China trade tensions would flatter the bullish growth signals seen in the global LEI and ZEW indices. Yet the turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. The turn in these indicators is so consistent, across so many countries, that we suspect it has more to do with the easier monetary policies, and the associated loosening of financial conditions, that have taken place in response to the uncertainty over global trade. Taken together, these signals are all bond-bearish, on the margin. The diffusion index of our global LEI has proven to be an excellent leading indicator of the real component of DM bond yields, leading the latter by around one year, and is pointing to higher yields ahead (Chart 4). At the same time, the inflation expectations component of DM yields (measured using CPI swaps rates) is also expected to drift higher in the next 6-12 months, led by firmer oil prices and some softening of the US dollar. Global central banks will maintain a dovish bias over at least the first half of 2020, to ensure that there is enough positive growth momentum to push inflation expectations back up towards policymaker targets. This means that there can be some modest bear-steepening of government bond yield curves across the major DM nations over the next 6-9 months (Chart 5), as policymakers will not begin to raise policy interest rates too soon. Chart 4Global Yields Moving Higher For The Usual Reasons Chart 5Higher Inflation Expectations = Steeper Yield Curves Chart 6Global Yields Starting To Climb Above Moving Averages The notable exception is the UK. Inflation expectations there are already elevated due to Brexit uncertainty, which has depressed the pound and reduced UK productivity growth while forcing the Bank of England to maintain highly accommodative monetary policy – all factors that should result in higher UK inflation, both realized and expected. Yet even there, the nominal Gilt curve has been bear-steepening of late, alongside the similar trends seen in the other major DM countries like the US and Germany. The move upward in global bond yields suggested by our most reliable leading indicators suggests more of a slow grinding increase in yields (through higher inflation expectations) rather than a rapid acceleration of real rates. The latter would require a shift towards more hawkish central bank monetary policies, which will not happen before there is a sustained pickup in both growth momentum and inflation expectations. The Federal Reserve is the central bank that is likely to lead that transition, but not until late in 2020 and perhaps not until after the November US presidential election. At the country level, the move upward in yields since the early September lows has begun to take out some technical targets (Chart 6). The benchmark 10-year government bond yield is above the 100-day moving average for the major DM countries (the US, Germany, UK, Japan, Canada and Australia). The 200-day moving averages represent the next key resistance level for those markets. The 10-year yield in Japan has already breached that level, perhaps signaling that similar breakouts are on the way in other major markets. Bottom Line: The latest readings from our global leading economic indicator and the global ZEW index show further improvement in growth momentum. Maintain a below-benchmark stance on global duration, favoring inflation-linked bonds/swaps over nominal bond exposure, while positioning for steeper government bond yield curves. Time To (Finally) Take Profits On Our New Zealand Spread Trades We have been structurally positive on New Zealand (NZ) government bonds since mid-2017. This was originally a shorter-term “tactical” view based on expectations that the Reserve Bank of New Zealand (RBNZ) would be forced to keep policy rates steady due to sub-par domestic economic growth and sluggish inflation. Since this was occurring at a time of improving global economic growth in 2017, especially in the US and euro area, we expressed our view as spread trades between 5-year government bonds in NZ versus equivalent maturity debt in the US and Germany (hedged back into US dollars and euros, respectively). The “tactical” trade turned into a medium-term recommendation, as the NZ economy and inflation slowed more than expected. NZ government bonds significantly outperformed global peers as a result, helping boost the returns on our recommended trades. The 5-year NZ-US yield spread has fallen from +74bps when we first initiated the trade to -52bps today, while the spread for 5-year NZ-Germany has narrowed from +292bps to +171bps (Chart 7). We now see several good reasons to take profits on those long-standing positions: NZ economic growth is set to improve The year-over-year growth rate of real GDP in NZ has slowed from 3.1% in mid-2017 (when we initiated our spread trades) to 2.1% in the Q2/2019 (Chart 8). This has occurred in both the manufacturing and services sides of the economy, based on the sharp drop in the PMIs (middle panel). Export growth has also slowed, particularly during the recent global manufacturing downturn, leading to sharp declines in business confidence and capital spending plans. The economic weakness was enough to push NZ real GDP growth below the rate of potential GDP - which is estimated by the RBNZ to have fallen from 3% to 2.5% due primarily to slowing population growth related to reduced net immigration into the country. Chart 7NZ Bonds Have Solidly Outperformed Chart 8NZ Growth Should Soon Bottom Out The long slump in NZ manufacturing appears to have ended, however. The manufacturing PMI index jumped 3.8 points to 52.6 in October, with the New Orders component rising 5.3 points to 56.2. This pushed the New Orders-to-Inventories ratio – a leading indicator of overall NZ business sentiment – to the highest level since March 2017 (bottom panel). The domestic side of the NZ economy is also set to improve (Chart 9). Consumer spending has been weighed down by both the structural factor of slowing immigration and the cyclical factor of slowing house prices. Median NZ house price growth has perked up of late, however, in response to the RBNZ’s rate cuts this year, which should help boost consumer spending through wealth effects. Business investment should also start to speed up as manufacturing activity improves, especially with the terms of trade (relative prices of NZ exports to imports) now starting to accelerate (middle panel). The external side of the economy is also set for some improvement. In the November 2019 RBNZ Monetary Policy Statement (MPS) published last week, the central bank laid out a very cautious forecast for an increase in the GDP growth of NZ’s trading partners in 2020 (bottom panel). The sharp pickup in the EM component of our global LEI, however, suggests that global growth, and demand for NZ exports, may be much stronger than the central bank envisions next year. NZ’s economy is running at close to full capacity In the November MPS, the RBNZ also presented its own estimates for spare capacity in the NZ economy, using a variety of economic models for both the output gap and the full employment “NAIRU” (Chart 10). The median estimate of the output gap models is around 0% and is expected to stay around those levels for the next two years. The NZ unemployment rate is projected to be stable around 4% through 2020, which is close to the median model estimate of NAIRU. Thus, by the central bank’s own reckoning, the NZ economy is running at full capacity. Chart 9An Upside Growth Surprise In 2020? Chart 10NZ Does Not Need More Rate Cuts The RBNZ also produces model estimates of the neutral level of its policy rate, the Overnight Cash Rate (OCR). The current OCR of 1.0% is at the low end of the range of model estimates (bottom panel). This seems inconsistent with an economy that may be operating with no spare capacity, as the RBNZ’s other models suggest. Those models appear to be giving an accurate read on the inflationary tendencies of the NZ economy, though. Underlying NZ inflation is accelerating While headline CPI inflation fell to 1.5% in Q3/2019, close to the bottom of the RBNZ’s 1-3% target band, core CPI inflation accelerated to 1.9% - just below the midpoint of the band (Chart 11). The decline in headline inflation can be attributed to weakness in the tradeables component of the CPI, but this should soon start to increase based on the lagged impact of the acceleration of energy prices denominated in NZ dollars (middle panel). With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. Meanwhile, non-tradeables (i.e. domestically generated) CPI inflation has accelerated over the past few quarters and is now at 3.2% - above the top end of the RBNZ inflation band. This has occurred alongside an acceleration of average hourly earnings growth to 4.2%, suggesting a tight labor market that confirms the message from the RBNZ’s NAIRU models. NZ monetary conditions are now very easy With both growth and inflation dynamics now bottoming out in NZ, the RBNZ’s recent rate cuts may be working too well. The central bank also produces estimates of the neutral real rate in NZ, using the same “r*” framework used by the US Federal Reserve (Chart 12). The neutral real rate is estimated to be 1.25% which, when added to the 2% midpoint of the RBNZ’s target band, produces a neutral nominal rate of 3.25% - a whopping 225bps above the current OCR rate. Chart 11NZ Inflation Bottoming Out Chart 12NZ Monetary Conditions Now Appear Too Easy With rates so far below neutral in nominal terms, it is no surprise that the NZ dollar is at such low levels versus both the US dollar and the euro (bottom panel). This is providing an additional easing of monetary conditions that will help boost NZ growth and inflation over at least the next year – and likely force the RBNZ to stop cutting rates and, perhaps, even begin to lay the groundwork for taking back some of the 2019 rate reductions. In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit. NZ yields look too low versus the US and Germany Our fair value regression models for both the 5-year NZ-US spread (Chart 13), and the 5-year NZ-Germany spread (Chart 14), are both signaling that NZ government bonds are relatively expensive. These models estimate the fair value of the spreads as a function of relative central bank policy rates, relative unemployment rates and relative inflation rates. Both models suggest that the cross-country yield spreads have tightened too much relative to the economic fundamentals of NZ, the US and Germany. Chart 13NZ Government Bonds Look Expensive Versus US Treasuries ... Chart 14... And German Government Debt In sum, the combination of improving growth momentum, accelerating inflation dynamics, loose monetary policy settings, and overvaluation make a powerful case for closing out our NZ-US and NZ-Germany spread trades at a healthy profit (see the Tactical Overlay Trade table on Page 16). Bottom Line: The RBNZ is likely done cutting rates, amid signs that the momentum is bottoming for both growth and inflation in New Zealand. Take profits on our long-standing recommended NZ-US and NZ-Germany 5-year government bond spread trades Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The bond market’s bearish trend remains intact, but suffered a hiccup last week as some economic data disappointed. Our sense is that the worst of the global growth slowdown is over, but a rebound in our preferred global growth indicators – Global Manufacturing PMI, US ISM Manufacturing PMI and CRB Raw Industrials index – is necessary to push bond yields higher. We expect that such a rebound will transpire in the coming months. The Credit Cycle & Inflation: Low inflation expectations will keep monetary policy accommodative for the next 6-12 months. This justifies a positive outlook for spread product excess returns. Eventually, inflation will return and force the Fed to adopt a more restrictive stance. This will lead to the end of the credit cycle. We will get more defensive on spread product when long-maturity TIPS breakeven inflation rates move above 2.3%. Municipal Bonds: The main issues facing municipal bonds are long-run in nature, mostly related to underfunded state & local government pensions. These concerns are propping up yield ratios at the long-end of the muni curve, but aren’t likely to cause a wave of ratings downgrades until revenue growth slows during the next downturn. For the time being, investors can grab an attractive after-tax yield premium in long-maturity munis. Hiccups Judging by the bond market, recession fears appear to have peaked in late August. Since then, the Treasury index has lost 2.1% versus a position in cash and the 2/10 yield curve is 23 bps steeper (Chart 1). Curve steepening has also occurred via the real yield curve, while the breakeven inflation curve is moderately flatter, consistent with our expectations.1 However, this bearish bond market trend suffered a set-back last week. The 10-year yield fell 10 bps, back down to 1.84%, and the 2-year yield fell 7 bps to 1.61%. The move was driven by an increase in skepticism about the US and China’s “phase 1” trade deal and some mixed economic data. Both industrial production growth and capacity utilization remain well above their 2016 lows, consistent with stronger PMIs.  October’s Industrial Production report was the worst of last week’s data releases. Production declined 0.8% on the month and capacity utilization fell from 77.5% to 76.7% (Chart 2). The data were significantly influenced by the General Motors strike, but the index still fell 0.5% with motor vehicles and parts stripped out. In our prior discussions of the divergence between “hard” and “soft” economic data, we pointed to relatively strong industrial production as a reason to expect a snapback in depressed manufacturing PMIs.2 This month’s weak print challenges that view, though both industrial production growth and capacity utilization remain well above their 2016 lows, consistent with stronger PMIs. The New York Fed’s Manufacturing PMI also came in roughly flat last week, and continues to point to a rebound in the national index (Chart 2, bottom panel). Chart 1Bumps On The Road ##br##To Higher Yields Chart 2Disappointing Data, But Well ##br##Above 2016 Lows October’s retail sales were also released last week, and we continue to observe a wide divergence between strong consumer spending growth and falling consumer confidence (Chart 3). As with the divergence between industrial production and the manufacturing PMI, we suspect that negative sentiment about the US/China trade war has unduly depressed consumer and business sentiment. Sentiment should rebound if trade tensions ease in the coming months, as we expect. Finally, we note that the CRB Raw Industrials index remains downbeat (Chart 4). We should continue to view the recent increase in bond yields as tenuous until it is confirmed by a rebound in this global growth bellwether. Chart 3Retail Sales Still Strong Chart 4Waiting On The CRB Index To Rebound Bottom Line: The bond market’s bearish trend remains intact, but suffered a hiccup last week as some economic data disappointed. Our sense is that the worst of the global growth slowdown is over, but a rebound in our preferred global growth indicators – Global Manufacturing PMI, US ISM Manufacturing PMI and CRB Raw Industrials index – is necessary to push bond yields higher. We expect that such a rebound will transpire in the coming months.   Inflation Will End The Cycle … But Not Anytime Soon As global growth improves during the next few months and recession fears fade into the background, discussion will once again turn toward questions about how much longer the credit cycle can run, and what will ultimately bring it to an end. On the first question, we find the slope of the yield curve to be an excellent indicator of the age of the cycle. Specifically, we like to split each cycle into three phases based on the slope of the 3-year/10-year yield curve: 3 Phase 1 starts at the end of the last recession and ends when the 3/10 slope flattens to below 50 bps. Phase 2 encompasses the period when the slope is between 0 bps and 50 bps. Phase 3 begins when the 3/10 slope inverts and ends at the start of the next recession. We expect Phase 2 to persist for some time given that inflation expectations remain downbeat. Table 1 shows that corporate bond excess returns are highest in Phase 1, when the yield curve is steep and spreads are tightening quickly. Excess returns tend to remain positive in Phase 2, but are much lower. Excess returns don’t usually turn negative until after the yield curve inverts and we enter Phase 3. Table 1Corporate Bond Performance During The Three Phases Of The Yield Curve Cycle Though some segments of the yield curve inverted in August, we do not think that the cycle has transitioned into Phase 3. The inversion was quite brief, and the measure we employ in our analysis – the monthly average of daily closing values of the 3-year/10-year slope – never broke below zero. The 3-year/10-year slope is currently +23 bps. We expect the current Phase 2 environment to persist for some time, and consequently, corporate bonds will deliver small positive excess returns relative to Treasuries. The reason why we expect Phase 2 to persist for some time is that inflation expectations remain downbeat (Chart 5). Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates are well below the 2.3%-2.5% range that is consistent with the Fed’s target. This means that the Fed has every incentive to maintain an accommodative monetary policy until inflation expectations are re-anchored. An accommodative policy stance will prevent the yield curve from inverting for any sustained period of time. Chart 5The Re-Anchoring Process Will Take Time The upshot is that a re-anchoring of TIPS breakeven inflation rates will be an important signal for us to get more defensive on corporate credit. When the 10-year and 5-year/5-year forward TIPS breakeven inflation rates move above 2.3%, the Fed will have less incentive to maintain an accommodative stance. The pace of tightening will likely quicken, leading to a sustained curve inversion and a transition into Phase 3 of the cycle. How Long Until Inflation Expectations Are Re-Anchored? Given our framework for thinking about the age of the cycle, the big question for our corporate credit call is: How long until inflation expectations are re-anchored? We have previously demonstrated that inflation expectations adapt to changes in the actual inflation data, and that this adaptive process occurs very slowly.4 Note that our Adaptive Expectations Model puts fair value for the 10-year TIPS breakeven inflation rate at 1.9%. This is above the current rate of 1.63%, but still well below our 2.3%-2.5% target range (Chart 5, bottom panel). The gradual nature of the adaptive process means that actual core inflation will probably have to overshoot the Fed’s 2% target for a period of time before long-dated expectations are firmly re-anchored. With that in mind, we are still a long way away from inflation posing a problem for the credit cycle. Core CPI and core PCE inflation are running at year-over-year rates of 2.3% and 1.7%, respectively, both slightly below levels consistent with the Fed’s target (Chart 6).5 Trimmed mean measures are slightly higher and less volatile. They currently suggest that core inflation will remain in a slow and steady uptrend going forward. Any durable increase in core inflation will likely occur via the Core Services (ex. shelter and medical care) component.  Looking at the main components of core inflation, we see some reason to expect consumer price acceleration to cool in the coming months. Recent inflation gains have come mostly via the Core Goods component (Chart 7). This component tracks non-oil import prices with a long lag, and import prices have already rolled over. Meanwhile, shelter is the largest component of core inflation and we expect it will remain well supported in the coming months. The National Multifamily Housing Council’s Apartment Market Tightness Index has been in “net tightening” territory for two consecutive quarters (Chart 7, bottom panel). An above-50% reading from this index tends to coincide with rising shelter inflation. Chart 6Expect Core Inflation To Rise Slowly Chart 7A Closer Look At The Core CPI Components Ultimately, any durable increase in core inflation will likely occur via the Core Services (ex. shelter and medical care) component. This component has been relatively stable during the past few months (Chart 7, panel 3). Another interesting dynamic to monitor when assessing how long it will take for inflation to return is the labor share of national income. Chart 8 shows that the wage acceleration seen during the past few years has come mostly at the expense of corporate profit margins, and has not yet been significantly passed through to higher consumer prices. This is typical late-cycle behavior, and at some point firms will need to start raising prices in order to protect margins. Chart 8Where Will The Labor Share Peak? If we use the past few cycles as a guide, we see that the labor share of income peaked at above 70%. If this is an accurate road-map for the current cycle, then it means that firms can stomach quite a bit more margin compression, and it could be a long time before inflation pressures emerge. However, some recent research suggests that the labor share of income might peak at a lower level this cycle than in the past.6  This research documents that many industries are increasingly dominated by a small number of “superstar firms”. These firms have greater pricing power and might be able to sustain higher profit margins indefinitely. This would mean that inflationary pressures could re-emerge at a lower labor share of national income than in previous cycles. Bottom Line: Low inflation expectations will keep monetary policy accommodative for the next 6-12 months. This justifies a positive outlook for spread product excess returns. Eventually, inflation will return and force the Fed to adopt a more restrictive stance. This will lead to the end of the credit cycle. We will get more defensive on spread product when long-maturity TIPS breakeven inflation rates move above 2.3%. Strong Revenue Growth Supports Munis We continue to recommend an overweight allocation to municipal bonds due to attractive yield ratios, particularly for long maturities, and steady state & local government revenue growth. Chart 9 shows that Aaa Municipal / Treasury yield ratios were quite low earlier this year, but have increased significantly during the past few months. Yield ratios are above average pre-crisis levels for maturities of 10-years and greater. Against that back-drop of attractive valuations, credit quality trends are also supportive. Municipal bond ratings upgrades are outpacing downgrades (Chart 10), and history suggests that will continue until state & local government revenue growth slows. On that front, the three main sources of state & local government revenue are all growing at strong rates, a trend that should continue as long as the economic recovery is maintained. Municipal bond ratings upgrades are outpacing downgrades, and history suggests that will continue until state & local government revenue growth slows.  Of course, many state & local governments face long-run credit constraints, mostly related to underfunded pension obligations. This is almost certainly the reason why yield ratios for long-maturity bonds are so attractive. Crucially, these long-run issues will not be exposed until revenue growth slows during the next economic downturn, and investors have an opportunity to capture the attractive yield premium in the meantime. Chart 9Great Value At The Long End Chart 10Revenue Growth Will Remain Strong State governments have also made progress shoring up their balance sheets during the past few years. The National Association of State Budget Officers calculates that the overall state & local government total balance has returned back to 2006 levels, while rainy day funds have been built up considerably (Chart 11). Chart 11States Are Growing Rainy Day Funds Bottom Line: The main issues facing municipal bonds are long-run in nature, mostly related to underfunded state & local government pensions. These concerns are propping up yield ratios at the long-end of the muni curve, but aren’t likely to cause a wave of ratings downgrades until revenue growth slows during the next downturn. For the time being, investors can grab an attractive after-tax yield premium in long-maturity munis.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 2Please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 3 For more details on our analysis of the phases of the cycle based on the slope of the yield curve please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 5 The Fed targets 2% PCE inflation, which is historically consistent with CPI inflation between 2.4% and 2.5%. 6 https://economics.mit.edu/files/12979 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights There is little risk that inflation will heat up over the next several months, … : Weak growth is more of a threat to the global economy than inflation. … which means the Fed won’t be in any hurry to take away this year’s rate cuts, … : We expect the Fed to leave the target fed funds rate alone for nearly all of 2020. … giving the economy plenty of opportunity to overheat: If trade tensions move to the back burner, and global manufacturing activity revives, the “insurance” rate cuts executed by the Fed and other central banks may turn out to have been unnecessary. The investment punch line is that accommodative monetary policy is likely to push asset prices and Treasury yields higher: Our revised Rates View Checklist supports going back to a below-benchmark duration stance over the tactical timeframe, in line with our cyclical view. Feature BCA researchers’ latest monthly view meeting opened with a discussion of whether inflation or deflation is the bigger risk to financial markets. Should investors be more concerned about signs of overheating or stalling growth? With inflation unable to get traction in any of the major economies, we all agreed that growth is the more critical unknown. An investor who gets the growth call right has the best chance of getting broad asset class positioning right, along with country, sector, duration, credit and currency tilts. While we continue to believe that there are more inflation pressures beneath the surface of the US economy than most investors realize, they are highly unlikely to manifest themselves any time soon. At today’s low-single-digit levels, inflation’s investment import is limited to its impact on monetary policy. Inflation expectations remain far below the levels that are consistent with the Fed’s inflation target (Chart 1), and the Fed is likely to keep policy easy until they adjust higher. Though it is uncertain just what levels of realized inflation, or inflation expectations, would trigger the Fed’s reaction function, we are confident that inflation will not be an issue in the coming year. Chart 1No Pressure To Remove Accommodation Chart 2Global Revival Ahead? We expect that global growth will surprise to the upside, pulling bond yields and risk asset prices higher. BCA’s global LEI bottomed earlier this year, and the diffusion index that leads directional moves in the LEI has turned sharply higher (Chart 2). The improvement is consistent with the easing in global financial conditions and the tentative détente in the trade war. Although we will not count on a completed “Phase I” agreement until it is signed, financial markets’ allergic reaction to trade tensions seems to have encouraged the White House to back off lest it undermine its re-election prospects. Interest Rates – Looking Back Figure 1Rates View Checklist We rolled out our Rates View Checklist a little over a year ago to systematize our interest rate analysis and to clarify the rationale underpinning our views1 (Figure 1). Detailing the key series we monitor to anticipate the future direction of rates helps clients think along with us while giving them the chance to adapt the framework for their own purposes. As we were starting from a position of recommending below-benchmark duration, the checklist was aimed at identifying and tracking the factors that could encourage us to become more constructive about Treasury bonds. We never did warm to duration on a cyclical basis, though we did turn tactically neutral in mid-August. Part of the reason was that we did not give enough weight to events outside of the US. Highly-rated, developed-market sovereign bonds are substitutes for one another, and there is a limit to how much currency-adjusted yields can deviate across countries. Very low to negative yields in the UK, France, Germany and Switzerland have exerted a magnetic pull on Treasury yields (Chart 3), and the different sovereigns should move in tandem going forward, with currency-hedged yields observing a tight range. Chart 3Birds Of A Feather The short end of the yield curve exerts considerable influence on rates across all maturities. Our US bond strategists’ golden rule of bond investing homes in on the deviation between actual and expected moves in the fed funds rate as the key determinant of duration positioning outcomes. Following their lead, our checklist is oriented around anticipating the Fed’s reaction to important incoming data. It seems to have done its job over the last year, highlighting the factors that drove the Fed to switch from dialing back accommodation to dialing it up. Although we never checked more than four of the eleven boxes in the checklist – Inverted Yield Curve, Sluggish Rise in Realized Inflation, Sluggish Rise in Inflation Breakevens and International Duress – those four boxes were enough to inspire the Fed’s dovish pivot. That pivot has so far encompassed three quarter-point rate cuts, pruning back the funds rate to 1.75% from 2.5%. It turns out that the key items in the checklist were the orientation of the yield curve; sluggish inflation expectations that the Fed worried could become “unanchored on the downside;” and the shadow of trade tensions that seem to have induced a global manufacturing recession, even if they have yet to infect the DM economies’ larger services sector. They tipped the scales for Fed policy and we will be especially alert to them going forward. Interest Rates – Looking Ahead Figure 2Revised Rates View Checklist While our interpretation of the checklist left something to be desired, we are convinced that the checklist approach is sound. We return to its framework for insight into the current rates outlook, after making a few tweaks to shore it up (Figure 2). Starting with Fed perceptions, there is still some daylight between our fed funds rate expectations and the market’s, as we think the Fed is done cutting, while the money market assigns a high probability to the possibility of one more cut (Chart 4). The combination of rate cuts and the rally in 10-year Treasury yields got the yield curve back to its typical upward-sloping orientation in October (Chart 5), so we can now uncheck the inverted curve box. We see the five-month inversion as a reason to be more vigilant, but given the unusually negative term premium, we are not treating it as a hard-and-fast sign of looming weakness. The money market has priced out all but one more rate cut, and the yield curve is no longer inverted, suggesting that recession fears are abating. Chart 4Looking For One More Cut Chart 5The Curve Is No Longer Inverted Chart 6Inflation Is Muted, ... We continue to check both of the sluggish inflation boxes. Realized inflation measures, headline and core, have slumped (Chart 6), and below-target inflation expectations remain a hot-button concern, judging by Fed speakers’ repeated references to them. The Fed has strapped itself to the mast with all its talk about inflation expectations, and it will not begin removing accommodation until inflation expectations revive. We cannot directly observe the output gap, but nearly 3% growth in 2018, and a rip-roaring labor market, offer solid evidence that it has closed and we leave its box unchecked. Labor market indicators unanimously point to the conclusion that monetary accommodation is not necessary. The unemployment rate is a full percentage point below the Fed’s and the CBO’s estimates of NAIRU. Ancillary indicators like the broader definition of unemployment including discouraged workers and involuntary part-time workers (Chart 7, top panel), and the openings (Chart 7, middle panel) and quits rates (Chart 7, bottom panel) from the JOLTS survey, testify to an extremely tight labor market. We expect that the pause in wage acceleration will prove temporary (Chart 8). Chart 7... Despite A Red-Hot Labor Market Chart 8Wage Gains Will Pick Up Again Chart 9No Overheating In The Real Economy With cyclical spending well short of past business cycle peaks (Chart 9), the real economy isn’t exerting any pressure on the Fed to intervene to choke off the expansion. (Although a modest pace of Fed hikes would support below-benchmark duration positioning, aggressive tightening to cut off overheating leads to recessions, and would favor long-maturity Treasuries.) We have removed the financial sector imbalances box because there has been no apparent follow through from Governor Brainard’s speech last September, which appeared to set the stage for tightening on the basis of frothy credit conditions. We maintain the international duress box, which is meant to alert us to an overseas crisis or near-crisis that could spark a flight to quality that depresses Treasury yields and/or inspires the Fed to pursue easier policy in an attempt to stave off contagion risks. Green shoots in manufact-uring, here and abroad, support the idea that growth outside the U.S. could be poised to accelerate. Chart 10Global Manufacturing Is Coming Back ... Chart 11... And US Manufacturing May Have Bottomed We add “Flagging Global Growth” to address the global growth blind spot that undermined our call last year. Our US Bond Strategy colleagues find that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials Index are the global growth measures that exert the strongest influence on Treasury yields. The Global Manufacturing PMI has risen off its lows over the last three months and is within striking distance of getting back above the 50 contraction/expansion line, led by the US2 and China (Chart 10). The outlook for the US ISM Manufacturing PMI looks good on several counts. First, the comparatively modest manufacturing sector tends to move with the much larger services sector, and the sharp bounce in the Services PMI bodes well for the Manufacturing PMI (Chart 11, top panel). Within the manufacturing survey, New Export Orders’ leap back over 50 suggests that the global economy may have already seen the worst of the manufacturing weakness that has swept the rest of the world (Chart 11, bottom panel). The jury is still out on the CRB Raw Industrials-to-gold ratio (Chart 12, top panel), as industrial commodity prices have yet to show any spunk (Chart 12, bottom panel).   Chart 12Commodities Have Yet To Turn Chart 13A Weaker Dollar Would Support Higher Rates With our trio of indicators mixed-to-positive on balance, we leave the global growth box unchecked. We have also added a dollar box to monitor when Treasury yields are drifting out of alignment with other sovereign yields. If the dollar and Treasury yields rise together, we would view the rise in yields as suspect and at risk of being reversed.3 There doesn’t appear to be any decoupling pressure now, as Treasury yields have risen while the dollar has bumped around in a narrow range (Chart 13, top panel), and bullish sentiment toward the dollar has cooled off, pointing the way to a currency-approved path to higher yields (Chart 13, bottom panel). Bottom Line: We check only two of the boxes in our revised rates checklist (Figure 2), supporting a below-benchmark duration stance. Investment Implications Like all investors, we hate to get anything wrong. We were wrong on rates, though, failing to see the potential for the 10-year Treasury yield to fall to 1.5%. The duration miss undermined results within the fixed income sleeve of our recommendations, as we didn’t take it off until the 10-year Treasury yield had fallen to 1.74% .4 We have modified our rates checklist to force ourselves to be more aware of the world beyond the US, but the available data still support below-benchmark duration positioning, and we now recommend going back to it over the tactical (0-3-month) timeframe. The date when monetary policy turns restrictive has been pushed out, and so have the dates when the bull markets in risk assets will end. We note that our overall asset allocation calls have performed well. Since we upgraded equities in our first 2019 report,5 the S&P 500 Total Return Index has gained 24% while our Treasury underweight, as proxied by the Bloomberg Barclays US Treasury Total Return Index, is up 7% (Chart 14, top panel). Since we upgraded spread product in late January,6 the Bloomberg Barclays US Corporate Investment Grade and High Yield Total Return Indexes are up 12% and 8%, respectively, versus the Treasury Index’s 7% (Chart 14, bottom panel). Chart 14Underweighting Treasuries Has Been The Way To Go The run-up to the Fed’s series of mid-cycle rate cuts doomed our duration call, but it has fortified the case for overweighting equities and spread product. We still expect the expansion, the equity bull market, and spread product’s long period of generating excess returns to die at the hands of the Fed. Now that the date when monetary policy settings become restrictive has been indefinitely delayed, the end-dates of the equity and credit bull markets have as well. We continue to recommend overweighting equities and spread product, and underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 17, 2018 US Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com. 2 The Global PMI is compiled from Markit’s individual country PMIs, so the chart shows the Markit US PMI instead of the more familiar ISM measure. 3 It the dollar were to rise significantly while Treasury yields rose faster than other DM sovereign yields, currency-adjusted Treasury yields would decouple from peer yields and arbitrage activity would likely bring them back down. 4 Please see the August 12, 2019 US Investment Strategy Weekly Report, “When The Facts Change,” available at usis.bcaresearch.com. 5 Please see the January 7, 2019 US Investment Strategy Weekly Report, “What Now?” available at usis.bcaresearch.com. 6 Please see the January 28, 2019 US Investment Strategy Weekly Report, “Double Breaker,” available at usis.bcaresearch.com.

Highlights A few indicators suggest that global growth will soon bottom. The bottoming process could prove volatile, but the duration of the slowdown suggests a V-shaped rather than U-shaped recovery. The dollar should weaken as higher-beta cyclical currencies rebound from deeply oversold levels. Sell the DXY index at 100. Aggressive short USD bets can be played via the NOK and SEK. The euro is also a natural beneficiary. Our favorite dollar-neutral bets include long AUD/CAD, SEK/NZD, GBP/JPY and short CAD/NOK. Feature The biggest question facing global investors is whether growth will pick up next year, and if so, what the durability of such a rebound will be. Any additional growth hiccups will cause the dollar to soar, and this week’s disappointing credit and industrial production numbers from China are a sober reminder that we are not out of the woods yet. Nevertheless, we believe a pickup in demand, especially emanating from outside the US, is forthcoming. This will favor more pro-cyclical currencies. Cyclical sectors of the equity market are already sniffing a growth rebound, and the dollar is off its peak for the year (Chart I-1). Historically, these have been good reflation indicators, especially when they are sending the same message. This is also a reminder to focus on where economic data will be six to 12 months from now rather than trade on yesterday’s news. Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming Policy shifts affect the economy with a lag, with a bottoming process that can be volatile and/or protracted. However, the duration of the current slowdown suggests we might be entering a V-shaped rather than U- or W-shaped recovery. Investors can track a few indicators to help calibrate the probability of the different scenarios playing out. The Message From Economic Variables There are a swath of economic variables one can follow to track the health of an economy, but we tend to focus on purchasing managers’ indices. This is because they are timely and have a good track record of confirming cyclical shifts in the economy. The problem is that for the most part, they tend to be coincident rather than leading indicators. Gauging the magnitude and duration of the cycle is also important to avoid false starts. The message is that the European manufacturing recession will be over by the first quarter of 2020.  In the US, financial conditions lead the ISM manufacturing index with a tight correlation (Chart I-2). Over the past 18 months, US bond yields have fallen. The historical precedent is that manufacturing activity should be reviving about now. The current reading is consistent with a rather explosive rise in the ISM manufacturing index, towards 60. Chart I-2The Drop In Bond Yields Is Consistent With An ISM Near 60 In Europe, the Sentix sentiment index, which surveys the balance of investors’ emotions between greed and fear, tends to be coincident. However, the ratio of the expectations component to the current situation, a second derivative measure of exuberance or capitulation, tends to lead changes in the PMI indices by six months (Chart I-3, top panel). Again, the message is that the European manufacturing recession will be over by the first quarter of 2020. Applying the same formula to the ZEW survey gives a similar message for Germany (Chart I-3, bottom panel). Even within the Japanese economy, which was heavily hit by the October consumption tax hike, some green shoots can still be uncovered. The expectations component of the Economy Watchers Survey, a comprehensive read across much of the smaller entrepreneurs that drive the local economy, is improving. This has nudged the difference between the expectations component and the current situation to the highest in 5 years. The message is corroborated by the economic surprise index (Chart I-4). Chart I-3A V-Shaped Recovery In European Manufacturing? Chart I-4Japan Green ##br##Shoots   Chinese credit growth was uninspiring in October, but the Caixin manufacturing PMI is now firmly above the 50 boom/bust level. More and more financial intermediation is being done through the bond market, and the drop in Chinese bond yields has eased financial conditions tremendously. This should encourage lending, which should lead to stronger economic activity, boosting demand for imports (Chart I-5). Rising Chinese imports will boost global growth. Chart I-5Chinese Imports Could Soon Rebound Bottom Line: For the most part, PMIs across many countries remain weak, but a few indicators are starting to point to an improvement next year. Given PMIs tend to be coincident, the most potent gains will be made by being early in the cycle. What Are Financial Markets Telling Us? The nascent upturn in our growth indicators is also coinciding with a positive signal from financial variables. Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful. Below are a few examples.  Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful.  Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are a small portion of overall FX flows, but the information coefficient is directionally quite good. The message is that in six months, EUR/USD will hit 1.16, GBP/USD will be at 1.4, AUD/USD at 0.75 and the USD/SEK at 8.5. Paradoxically, these are also closer to our own internal targets (Chart I-6). Chart I-6Inflows Into Cyclical ETFs The copper-to-gold, oil-to-gold, and CRB Raw Industrials-to-gold1 ratios often capture the transmission mechanism between easing liquidity conditions and higher growth. It is encouraging that these also tend to move in lockstep with US bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-7). The next confirmation will come with a clear breakout in these ratios. Chart I-7Global Growth Barometers Flashing Amber Correspondingly, in China, scrap steel prices have begun to rise faster than imported iron ore prices, suggesting an improving margin for steel producers. This is probably an indication that steel destocking has reached a nadir (Chart I-8). A renewed restocking cycle should benefit iron ore and other commodity imports and prices. In sympathy, the LMEX index appears to be making a tentative trough.  AUD/JPY breached the important technical level of 72 cents this year but has since recovered. The cross has failed to sustainably break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown in 2015-2016. Again, it appears reflation is winning the tug-of-war. Given speculators are neutral the cross, it suggests that any move either way will be powerful and significant (Chart I-9). Chart I-8Bullish Bottom-Up Signals From Metals Chart I-9Breakdown Avoided For Now An improving liquidity environment will be especially favorable for carry trades. High-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD have not yet broken down. These currencies are usually good at sniffing out a change in the investment landscape. The message so far is that the drop in US bond yields may have been sufficient to backstop any cascading selloff (Chart I-10). Chart I-10Carry Trades May Be Back In Style Soon Finally, bond yields across major markets are off their lows. Our strategy is to be selective as US dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the more potent Norwegian krone and Swedish krona. We have discussed at length our rationale for picking these currency pairs,2 but the bottom line is that they are deeply oversold and have probably been the primary vehicles used to express US dollar long positions. Bottom Line: It is too early to tell if the dollar will retest its highs before ultimately cresting, because part of the move has been driven by risk aversion/political uncertainty. Our bias is that some sort of trade détente is sufficient to rejuvenate economic activity given part of the slowdown, especially vis-à-vis capex, has been driven by uncertainty. Meanwhile, lots of monetary ammunition has already been fired over the past year.  Notes On Australia And New Zealand This week, the Reserve Bank of New Zealand surprised markets by keeping rates on hold, a volte-face to its dovish surprise this summer. In retrospect, this makes sense. First, the RBNZ may be watching the same indicators as us, and as such is seeing an imminent turnaround in the global economy. Keeping some ammunition will allow for more room to ease down the road. Second, the weakness in the currency has probably done the heavy lifting in boosting exports and supporting domestic income. Finally, Australia and China are New Zealand’s biggest trading partners, and the trade war along with rising pork prices have allowed for a terms-of-trade boost for New Zealand’s agricultural exports (Chart I-11). Slowing migration will go a long way in eroding a meaningful supply of employment and domestic demand in New Zealand. We are positive on the kiwi but believe it will underperform its antipodean neighbor. First, the AUD/NZD is cheap on a real effective exchange rate basis (Chart I-12). Meanwhile, a more pronounced downturn in Aussie house prices has allowed some cleansing of sorts, bringing them further along the adjustment path relative to New Zealand. We are willing to overlook this week’s disappointment in Australia’s job numbers, given the unfortunate wildfires that are destroying businesses and homes. Fiscal stimulus will be forthcoming, and reconstruction efforts will go a long way to boosting domestic demand Chart I-11A Terms Of Trade Boost Chart I-12AUD/NZD Is Cheap Meanwhile, the RBNZ began a new mandate on April 1st that now includes full employment in addition to inflation targeting. But given the RBNZ has been unable to fulfill its price stability mandate over the past several years, it is hard to argue it will find a dual mandate any easier. Slowing migration will erode a meaningful supply of employment and domestic demand in New Zealand (Chart I-13). The final catalyst for the AUD/NZD cross will be a terms-of-trade shock (Chart I-14). Iron ore prices may face further downside, given supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Given eliminating pollution is a strategic goal in China, this will be a multi-year tailwind Chart I-13Loss Of A Meaningful Tailwind For Employment Chart I-14Terms Of Trade Favors ##br##Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Footnotes 1 The CRB Raw Industrials-to-gold ratio is not shown here because of the steep correction in iron ore prices, after a resolution to a supply disruption. That said, iron ore prices are up 28% this year, versus 14% for gold. 2 Please see page 24 for a summary of our recent reports. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The Michigan consumer sentiment index edged up to 95.7 from 95.5 in November. The NFIB business optimism index slightly increased to 102.4 from 101.8 in October. Headline inflation recorded modest growth to 1.8% year-on-year in October while core inflation fell to 2.3%. Headline and core producer prices both slowed to 1.1% and 1.6% year-on-year respectively in October. The housing market remains healthy, with mortgage applications up 9.6% for the week. The DXY index appreciated by 0.2% this week. During his testimony this week, Fed Chair Powell suggested the growth outlook for the US remained favorable, based on labor market trends. That said, Europe and EM probably have more scope to outperform amid a global growth recovery, which will be a headwind for the US dollar.  Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index rebounded to -1 from -23.5 in November. Industrial production contracted by 1.7% year-on-year in September, however it is better than the contraction of 2.8% in the previous month and the expectations of a 2.3% drop. The preliminary GDP report showed that growth increased to 1.2% year-on-year in Q3, up from 1.1% in the previous quarter. Impressively, Germany steered clear of a recession. The euro fell by 0.2% against the US dollar this week. We expect the euro to recover along with the gradual improvement in the data. Moreover, the increased issuance of euro-denominated debt suggests some inflows into European corporate bond markets. This will benefit the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The trade surplus plunged to JPY 1 billion in September. The current account surplus narrowed to JPY 1.6 trillion from JPY 2.2 trillion. Machinery orders contracted by 2.9% month-on-month in September. On a yearly basis however, they grew by 5.1% year-on-year. Preliminary machine tool orders kept falling by 37.4% year-on-year in October. Preliminary annualized GDP growth slowed to 0.9% quarter-on-quarter in Q3. USD/JPY fell by 0.6% this week. Forward-looking data are showing more optimism on the domestic economy. This might prove that the damage from the tax hike is only a one-off effect. Continue to hold the yen, as both portfolio insurance, and a bet against more aggressive monetary stimulus from the BoJ. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mostly negative: The total trade deficit (including EU) widened to £3.4 billion in September. Preliminary GDP growth slowed to 1% year-on-year in Q3, from 1.3% in the previous quarter. Industrial production contracted by 1.4% year-on-year in September. Average earnings kept growing by 3.6% year-on-year in September. Moreover, the ILO unemployment rate fell further to 3.8%. Headline inflation fell to 1.5% year-on-year in October, while core inflation remained at 1.7%. GBP/USD increased by 0.4% this week. Despite the recent small rally, the pound is still undervalued on a PPP basis. With a lower probability of a hard-Brexit, our bias remains that the pound has more upside and will converge towards its long-term fair value. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: NAB business conditions and confidence both increased to 3 and 2 in October. Moreover, Westpac consumer confidence increased by 4.5% in November. The wage price index grew by 2.2% year-on-year in Q3. The labor market data was however disappointing, the unemployment rate slightly increased to 5.3% in October. There was a loss of 19K jobs in October, with 10K full-time and 9K part-time. AUD/USD fell by 1.3% this week, weighed down by the recent slide in iron ore prices and employment data. Given speculators are already very short the cross, this could be capitulation. We discuss Australia in this week’s front section. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: Inflation expectations fell slightly to 1.8% in Q4. The REINZ house price index grew by 1.1% month-on-month in October, down from 1.4% in the previous month. Migration into New Zealand continues to slow, with only 3440 newcomers in September. The New Zealand dollar rose by 0.6% against the US dollar this week. The main driver is that the RBNZ unexpectedly kept its interest rate unchanged at 1% this Wednesday. We are positive on the kiwi, but remain underweight against both the Australian dollar and the Swedish krona on valuation grounds. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly negative: Housing starts fell by 20K to 202K in October. Building permits fell by 6.5% month-on-month in September. The unemployment rate was unchanged at 5.5% in October. There was a loss of 1.8K jobs in October. However, average hourly wages yearly growth accelerated to 4.4%. New house prices contracted by 0.1% year-on-year in September. The Canadian dollar fell by 0.4% against the US dollar this week, given broad US dollar strength. CAD has handsomely outperformed its G10 commodity counterparts and some measure of rotation is due. We are short CAD/NOK and long AUD/CAD. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 2.4% year-on-year in October. The Swiss franc has appreciated by 0.6%, and the latest PPI numbers suggest deflation is becoming more and more rampant. Our bias remains that the SNB is likely to soon weaponize its currency like other central banks. We have a limit buy on EUR/CHF at 1.06. Stay tuned. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Producer prices fell by 13.8% year-on-year in October. This can largely be explained by the petroleum sector. Headline inflation increased to 1.8% year-on-year from 1.5% in October. Core inflation was unchanged at 2.2% year-on-year. The mainland GDP growth was unchanged at 0.7% in Q3. The Norwegian krone fell by 0.8% this week. The weakness in the krone remains much more than is warranted by underlying economic conditions. Should the DXY hit 100, we will be aggressive buyers of the krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Headline inflation increased to 1.6% year-on-year from 1.5% in October. The unemployment rate fell to 6% from a downward-revised 6.6% in October. The Swedish krona depreciated by 0.3% against the US dollar this week. Statistics Sweden has revised down the unemployment rate for the period from July 2018 to September 2019, due to a flaw in data quality. This has dampened the credibility of the employment data in Sweden and its effect on the exchange rate. That said, we maintain a pro-cyclical stance and remain bullish on the Swedish krona.  Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Client, I will be visiting clients in Paris, Amsterdam, and London next week. In lieu of our regular report, we will be sending you a Special Report from Matt Gertken, BCA’s Chief Geopolitical Strategist. Matt argues that US politics and the 2020 election represent the greatest source of geopolitical risk over the coming year, and possibly beyond. Best regards, Peter Berezin Highlights Having underperformed for more than ten years, non-US stocks are set to gain the upper hand over their US peers. A reacceleration in global growth, a weaker US dollar, and favorable valuations should all support non-US stocks next year. Meanwhile, one of the greater drivers of US equity outperformance – the stellar returns of tech stocks – is likely to dissipate. Investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. US Stocks: From Leaders To Laggards? US equities have handily outperformed their global peers since 2008. About half of that outperformance was due to faster sales-per-share growth in the US, a third was due to faster growth in US margins, and the rest was due to relative P/E expansion in favor of the US (Chart 1). Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Chart 1Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade Improving Global Growth Outlook Global growth should benefit next year from the dovish pivot by most central banks. The share of central banks cutting/raising rates leads global growth by about 6-to-9 months (Chart 2). Chart 2Lower Rates Should Help Spur Growth Chart 3The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The global manufacturing downturn is also coming to end as inventories continue to be run down. The auto sector, which has been at the forefront of the manufacturing slowdown, is finally showing signs of life. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In Europe, the new orders-to-inventory ratio of the Markit Europe Automobile PMI has moved back to parity for the first time since the autumn of 2018. In China, vehicle production and sales are rebounding on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies (Chart 5). Chart 4Chinese Auto Sector Is Bottoming Out Chart 5China: Structural Outlook For Autos Is Bright The trade war is a clear and present danger to our bullish outlook on global growth. The good news is that President Trump has a strong incentive to make a deal. A resurgence in the trade war would hurt the economy, which is Trump’s best selling point (Chart 6). As a self-described master negotiator, Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit with China. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will improve only after he is re-elected. Assuming a “Phase 1” agreement is concluded, global business sentiment should improve. Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else A détente in the trade war is unlikely to cause China to restart its deleveraging campaign. Credit growth is currently only a few points above trend nominal GDP growth, implying that the ratio of credit-to-GDP is barely increasing (Chart 7). The combined Chinese credit and fiscal impulse is still rising; it reliably leads global growth by about nine months (Chart 8). Chart 7China: The Deleveraging Campaign Has Been Put On The Backburner Chart 8Chinese Stimulus Should Boost Global Growth Faster Global Growth Should Disproportionately Benefit Non-US stocks The sector composition of international stocks is more skewed towards cyclicals than defensives compared to US stocks (Table 1). As a result, non-US stocks generally outperform their US peers when global growth accelerates (Chart 9). Table 1Cyclicals Are More Heavily Weighted Outside The US Stock Market We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin (Chart 10). Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 11). Chart 9Non-US Equities Usually Outperform When Global Growth Improves Chart 10Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields   The US Dollar Should Weaken Compared to most other economies, the United States has a large service sector and a small manufacturing base. This makes the US a “low beta” play on global growth. As a result, capital tends to flow from the US to the rest of the world when global growth picks up, putting downward pressure on the US dollar in the process (Chart 12). Chart 11Steeper Yield Curves Will Benefit Financials Chart 12The Dollar Is A Countercyclical Currency   Interest-rate differentials have been moving against the dollar for most of this year (Chart 13). This makes the greenback more vulnerable to a correction. Chart 13The Dollar Has Been Diverging From Rate Differentials This Year Chart 14Long Dollar Is A Crowded Trade Bullish sentiment towards the dollar also remains somewhat stretched. Net long speculative positions are near the top of their historic range (Chart 14). Our tactical MacroQuant model, which has an excellent track record of predicting short-to-medium term moves in the dollar, has dropped its bullish bias towards the currency (Chart 15).   Chart 15MacroQuant Has Soured On The US Dollar A weaker dollar will help boost commodity prices, which is usually good news for cyclical stocks (Chart 16). A softer dollar will also raise the USD value of overseas shares, thus making international stocks more attractive in common-currency terms. Valuations Favor Non-US Stocks There is an old investment adage which says that valuations are useless as a short-term timing tool. That is only partially true. While valuations by themselves offer little guidance as to where the stock market is going in the short run, combined with a catalyst, valuations can make a big difference. When stocks are cheap, a bullish catalyst can cause prices to surge; whereas when stocks are expensive, a bearish catalyst can cause them to plunge. Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Non-US stocks are currently trading at 13.8-times forward earnings. This represents a significant discount to US stocks, which trade at a forward PE ratio of 17.7. The valuation discount is even greater if one looks at other measures such as the cyclically-adjusted PE, price-to-book, price-to-sales, and the dividend yield (Chart 17). Chart 16A Weaker Dollar Tends To Support Commodity Prices Chart 17US Stocks Are More Expensive...   Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world (Chart 18). The rest of the gap is due to cheaper valuations within sectors. Financials, utilities, and consumer discretionary stocks, in particular, are quite a bit more expensive in the US than elsewhere (Chart 19). Chart 18…Even When Adjusting For Sector Weights Chart 19AEquity Sector Valuations: US Versus The Rest Of The World (I) Chart 19BEquity Sector Valuations: US Versus The Rest Of The World (II)   The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is markedly higher for non-US stocks (Chart 20). An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top. Some commentators have argued that the loftier valuations enjoyed by US stocks are warranted due to their superior growth prospects. While there may be some truth to that, it is worth noting that the IMF projects GDP growth (based on MSCI country weights) will be faster outside the US over the next five years (Chart 21). Chart 20Equity Risk Premia Remain Quite High Chart 21Growth Prospects Brighter Outside The US   One should also keep in mind that relatively fast US earnings growth is a fairly recent phenomenon. Between 1970 and 2008, European EPS actually grew slightly faster than US EPS (Chart 22). Earnings in emerging markets also increased more rapidly than in the US during the two decades leading up to the Global Financial Crisis. Chart 22US Earnings Have Not Always Outperformed The Role Of US Tech The large weight of the tech sector in the US stock market explains much of the superior performance of US stocks over the past decade. As Chart 23 illustrates, EPS in the I.T. sector has grown a lot more quickly than in other sectors. Chart 23US Earnings: Who Has Been Doing The Heaving Lifting? Chart 24S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector Looking out, there are four reasons why US tech stocks may be due for a breather. First, tech valuations have gotten stretched relative to the broader market. Second, tech margins have risen to unprecedented high levels. We estimate that about half of the increase in S&P 500 profit margins since 2007 has been due to I.T. (Chart 24). Even that understates the role of tech in the expansion of profit margins because Standard & Poor’s no longer classifies some large-cap behemoths such as Google and Facebook as I.T. companies. Third, tech companies may face increased regulatory scrutiny in the years ahead stemming from alleged privacy violations, perceived monopolistic behavior, and worries about the censorship of online speech. This could weigh on sales and earnings growth. Fourth, the growth in private equity funds is likely to limit the number of tech companies that go public at a very early stage. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at a young stage in their development (Table 2). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US has fallen by more than half over the past two decades (Chart 25). The median age of tech companies at the time of IPO has risen from around 7 in the 1990s to 12 years today (Chart 26). Table 2Big Gains From Once Small Companies Chart 25The Number Of Publicly Listed Companies Fell   Chart 26Tech Companies Entering The Public Arena Are Now More Mature Had Uber gone public as a small, upstart company not long after it was founded in 2009, it probably would have also made public shareholders a lot of money. Instead, it ended up going public this year with a market cap of $75 billion, only to see it shrink to as low as $40 billion in the ensuing six months. We won’t even mention what would have happened if WeWork had gone public. Investment Conclusions An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top: The first during the “Nifty 50” era of the late 1960s, the second during the 1990s dotcom boom, and the third during the recent FAANG craze (Chart 27). It is too early to say whether FAANG stocks have peaked, but it is worth noting that the group has underperformed the S&P 500 since May (Chart 28). Chart 27Putting The Recent FAANG Craze Into Context Chart 28FAANG Stocks And The Market Chart 29Has The Underperformance Of Value Run Its Course?   Regardless of whether the secular outperformance of US equities is ending, the cyclical backdrop that we foresee over the next 12-to-18 months – characterized by faster global growth, a weakening dollar, and higher commodity prices – is likely to favor non-US stocks. As such, investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. Consistent with this, we are initiating a new recommendation to go long the MSCI ACWI ex USA index versus the MSCI USA index in dollar terms. Looking across the various stock markets outside the US, we are particularly fond of Europe. Net profit margins among companies in the STOXX Europe 600 index are about three percentage points below the S&P 500. This gives European companies greater scope to boost earnings. European banks are especially attractive, sporting a forward PE of 8.3, a price-to-book ratio of 0.6, and a dividend yield of 6.1%. Lastly, on the question of style investing, we would note that the relative performance of the MSCI value and growth indices closely tracks the performance of global financials versus I.T. (Chart 29). Given our preference for the former over the latter, we suspect that value will outperform growth next year.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights Saudi Aramco likely will IPO 1-2% of the company next month on its local bourse; retail investors reportedly will get up to 0.5%. The IPO will value Aramco within a range estimated at less than $1 trillion to more than $2 trillion. China’s interest in Aramco goes back almost four years to when the IPO was first proffered. It reflects an economic and geopolitical calculus encompassing more than an equity claim on the world’s largest, lowest-cost, most profitable oil company. Investing in Aramco gives it a stake in producing oil it desperately needs at home – as its imports from KSA attest – and supports its goal of filling some of the power vacuum left by the US pivot away from the Middle East (Chart of the Week). For the Kingdom of Saudi Arabia (KSA), stronger ties with China will ground its Asian marketing efforts, and deepen China’s stake in the unimpeded flow of its exports. With tensions in the Gulf remaining high, this is crucial. In addition to the mutuality of KSA’s and China’s interests, “patriotic participation” by Saudi investors will help push Aramco’s valuation close to $2 trillion. A post-IPO let-down – not unusual by any stretch – is likely. Feature Chart of the WeekChina’s Oil Production Stagnates, While Imports From KSA Surge Dear Client, This week, BCA Research’s Geopolitical Strategy and Commodity & Energy Strategy explore the Saudi Aramco IPO scheduled for next month and its larger implications for the global economy. In keeping with our tradition, we take a multidimensional approach – financial, economic and geopolitical – consistent with our unique analytical endowment. We trust you will find this report’s approach and analysis useful in shaping your convictions. Matt Gertken and Bob Ryan The Kingdom of Saudi Arabia (KSA) is in an all-out sprint to diversify its economy away from a near-total dependence on oil exports by 2030 (Chart 2). Time is short. The IPO of Saudi Aramco is the sine qua non of this effort, as it will fund the investment required to effect this transformation’s ambitious goals (Table 1, Chart 3). Investing in KSA’s production and refining capabilities is attractive to China. Table 1Vision 2030 Highlights Chart 2Breaking Oil Dependency... China is engaged in an all-out effort to become self-sufficient in oil and gas production, given the vulnerabilities in its hydrocarbon-supply chain.1 Chart 3...Drives KSA's Vision 2030 Local oil-industry executives doubt this is even remotely attainable, which is one reason we believe investing in KSA’s production and refining capabilities via the Aramco IPO is so hugely attractive to China. It helps explain why policymakers sanctioned an investment of up to $10 billion in the IPO by various state-owned enterprises and funds.2 Given our expectation the IPO will value Aramco closer to $2 trillion than not, a 1-2% float would amount to between $20-$40 billion, meaning China – via its state-owned Silk Road Fund, Sinopec Group and China Investment Corp., et al – could account for as much as a quarter of the IPO if it prices out as we expect, and these state-owned investors pony up the full $10 billion being discussed in the press.3 Aramco’s Red Herring Released November 9, the Aramco Red Herring is as interesting for what it includes as what it leaves out.4 In the first six months of this year, Aramco production amounted to 13.2mm b/d of oil equivalent, 10.0mm b/d of which was crude oil and condensates. This was down slightly from the 13.6mm b/d of oil equivalent produced last year. The company notes that in 2016-18, it accounted for 12.5% of global crude output, and that its proved liquids reserves were “approximately five times larger than the combined proved liquids reserves of the Five Major IOCs,” or independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world (Chart 4). For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Investors will not know how that translates to a dividend yield until the actual number of shares floated is known. Chart 4Aramco Profitability Is Huge Chart 5Aramco Absorbs Most Of OPEC 2.0’s Production Cuts, Outside Iran, Venezuela The Red Herring foresees a compound annual growth rate in demand for the Kingdom’s oil, condensate and natural-gas liquids output of 0.9% p.a. between 2015 and 2025. Demand growth is expected to level off some time around 2035. In this baseline scenario, Aramco sees itself gaining market share globally over this period. In an alternative scenario, the company notes that if there is “a more rapid transition away from fossil fuels,” which sees demand for its hydrocarbons starting to decline in the late 2020s, “the Kingdom’s share of global supply is also expected to increase through 2050.” Saudi Arabia and Russia are the putative leaders of OPEC 2.0, the producer coalition formed at the end of 2016 to manage global oil supply growth, following a market-share war launched by OPEC in 2014. The coalition has an agreement in place to keep 1.2mm b/d of production off the market until the end of 1Q20. The Kingdom, via Aramco, has been shouldering the lion’s share of OPEC 2.0’s production restraint, outside of Iran and Venezuela, which have seen their production and exports slide due to US sanctions (Chart 5). On Wednesday, KSA informed OPEC (the original Cartel) the IPO of Aramco would not affect its commitments under the OPEC 2.0 deal.5 The IPO Will Bring KSA And China Closer China has been keen to invest in Aramco since the IPO was first floated almost four years ago. This reflects an economic and a geopolitical calculus encompassing more than simply securing an equity claim in the world’s largest, lowest-cost, most profitable oil company. An Aramco investment gives China a stake in producing oil it critically needs at home. China’s oil demand has been growing while its domestic production has been stagnating for the most part, despite the new-found emphasis on becoming self-sufficient. This is reflected in surging imports – totaling just over 10mm b/d in September, an 11% increase over August levels. China’s oil demand is expected to grow ~ 3.5% this year and next, averaging ~ 14.8mm b/d. China National Petroleum Corp. (CNPC) estimates China’s oil demand will peak in 2030 at 16.5mm b/d.6 China’s vulnerability to oil imports – caused by its rising import dependency and US maritime supremacy – has prompted President Xi to order increased exploration and production domestically. The trade war and US sanctions on Iran and Venezuela – two long-time crude-oil suppliers to China – drove this point home: Imports from Iran fell 46% y/y in the January – September period to 357k b/d, while imports from Venezuela fell 15% to 306k b/d.7 For its part, KSA views China as one of its primary growth markets, as its Red Herring attests. It will be investing in additional refining capacity there and view the market as key to its petchems growth. “The Company’s strategy is to continue increasing its in-Kingdom refining capability and expand its strategically integrated downstream business in high-growth economies, such as China, India and Southeast Asia, while maintaining its current participation in material demand centers, such as the United States, and countries that rely on importing crude oil, such as Japan and South Korea.” Both KSA and China would benefit from deeper economic engagement. Net, both KSA and China would benefit from deeper economic engagement, which the IPO will foster. It is not inconceivable representatives from Chinese state-owned or –affiliated entities could sit on Aramco’s board, which would provide even “greater assurance over its crude oil and refined product supplies going forward,” as we noted in a Special Report published in November 2017.8 This is a critical concern for China, with domestic production stagnating and demand for crude oil, refined products and petchems increasing. Evolution Of China’s Middle East Role While China’s involvement in the Middle East has steadily been growing in energy, trade and investment generally, it has espoused “a vision of a multipolar order in the Middle East based on non-interference in, and partnerships with, other states – one in which the country will promote stability through ‘developmental peace’ rather than the Western notion of ‘democratic peace’,” according to a recent paper from the European Council on Foreign Relations.9 China’s growing interest in the Middle East is fundamentally supportive of the Gulf Arab reform agendas. But geopolitical risk is still elevated in this region (Chart 6), especially over the one- to three-year time frame. This is primarily due to the far-from-settled conflicts between the US and China and the US and Iran. First take the US-China conflict as it pertains to the Middle East. As China’s economy has boomed, so has its import dependency. Over the past two decades Beijing's reliance on Middle Eastern crude oil has ballooned (Chart 7). The result is a deep strategic vulnerability for China. Economic and political stability depend on sea lanes that are, from China’s perspective, implicitly threatened by the United States and its allied maritime powers. Chart 6Geopolitical Risk Is Elevated In The Middle East Chart 7Beijing's Reliance On Middle Eastern Oil Has Ballooned Hence Beijing has devoted ever greater efforts over the past two decades to building a blue-water navy charged with securing its “lifeline” running from the Persian Gulf through the Strait of Malacca and the South China Sea to China’s hungry coastal cities (Map 1). This naval development is a disruptive process, as the US, Japan, Australia and others are seeking to maintain control of the Indo-Pacific seas along with China’s rivals like India. Map 1The Belt And Road Program Until recently, Beijing proceeded carefully in order not to galvanize efforts to oppose its growing influence. It has only timidly begun establishing forward military bases abroad — namely in Djibouti, Africa — and its activity at key civilian ports such as Gwadar, Pakistan, and Hambantota, Sri Lanka, is developing only gradually. The creation of a new “maritime Silk Road” is a long, drawn-out affair. However, slowly but surely Beijing aims to lessen its vulnerability to the US at strategic chokepoints like Malacca and the Persian Gulf. The US and allies will respond — and this will generate geopolitical risk. Thus naval conflict is a persistent “Black Swan” risk. China’s chief obstacle is America’s strategic dominance in the region. Second comes the US-Iran conflict as it pertains to China. In response to US sanctions against Iran, China has had to increase its oil imports from Arab Gulf states. Beijing — inherently a continental power — is seeking overland routes of trade and investment to acquire Siberian, central Asian, and Middle Eastern resources, which cannot be interdicted by the US. Hence the Belt and Road Initiative (BRI). US Still Limits China’s Middle East Options The BRI is the umbrella term for a process that began in the 2000s. China recycles its large current account surpluses into land and resources in the rest of Asia so as to maximize supply lines and diversify its savings away from US Treasurys (Chart 8). This is also a way for Beijing to export its industrial overcapacity, particularly in construction. This BRI process faces an important limitation in that Beijing’s current account surpluses have drastically declined (Chart 9). Even so, this decline will result in greater concentration on strategic targets. The Middle East is vital both because its energy could someday be accessed overland and because it could serve as an export market in itself. It could also become a way-station for greater trade to Europe and all of Eurasia. Chart 8China Is Diversifying Its Savings Away From US Treasurys Chart 9China's Falling Current Account Surplus Limits BRI Investments The instability of BRI countries delays China’s plans for regional investment, construction, transportation, and logistics. And China lacks the appetite for overseas political and military intervention necessary to shape the domestic environment in the relevant countries — especially given that the US remains the dominant power. China’s limited agency in Iraq is case in point. It is even severely limited in allied countries like Pakistan. And it has rocky relations with some of the key regional powers, such as Turkey. Chart 10 Yet the chief obstacle is America’s strategic dominance in the region and specifically its conflict with Iran. US foreign policy keeps Iran isolated and frequently forces China to impose sanctions. Since the Trump administration imposed “maximum pressure” on Iran, in May 2019, Beijing has drastically reduced oil imports and withdrawn from the $5 billion South Pars natural gas project (Chart 10). This was partly prompted by Washington’s use of secondary sanctions that threatened to cripple China’s leading tech companies for violating Iranian sanctions. Iran’s inability to open up to the outside world prevents China from fully executing its broader overland strategy. China is not yet capable of confronting Washington over Iran. The 2020 US election is therefore a critical juncture — the re-election of the Trump administration would likely prolong the current conflict with Iran. It is unlikely to lead to full-scale war, but that scenario cannot be fully ruled out given Trump’s lack of constraints in a second term. Whereas a new Democratic administration would almost certainly return to the Obama administration policy of détente with Iran, aimed at containing the country’s nuclear program in exchange for economic opening. Either way, Beijing faces a multi-year period in which it must prepare for US pressure on the high seas and possibly also in Iran. GCC’s Attraction To China The above considerations provide a clear reason for Beijing to deepen its relations with the Gulf Arab states, particularly Saudi Arabia and the UAE. These states are increasingly attracted to China not only as an energy customer and investor but also as a provider of high-tech goods, arms, and telecom equipment that is necessary for their productivity and useful for their surveillance and repression of domestic dissent. Deepening its trade relationship with KSA via a meaningful equity position in Aramco would present the perfect opportunity for China to take a meaningful step toward establishing the yuan as a global reserve currency. If KSA and the other GCC states begin accepting yuan as payment for their oil and products, and they begin spending their yuan on Chinese-made goods and services, two-way trade could expand significantly and rapidly. The RMB doesn’t have to be fully convertible to USD or euros for that to happen. Such a yuan-trading bloc would encompass oil and refined products, natural gas and liquids, and goods and services made in the GCC and China. This bilateral trade would provide a base from which to build out the yuan as a global reserve currency. This would neither be a forced evolution nor a hurried one. It would naturally evolve, which would ensure its durability. The US may attempt to prevent China from gaining influence in this way, but that would require a concerted effort. And such an effort is not likely to develop until 2021 or 2022 at the earliest. It will depend on the US election outcome, the 2020-24 administration’s foreign policy, and US-China negotiations. Hence China’s evolving role is positive for its supply security as well as for the reform agendas of the Gulf Arab states as they attempt to shift away from oil dependency. The problem is that China cannot ultimately guarantee the stability of the Arab states while they reform. China and Europe are energy importers that require stability in the Mideast, while Russia and increasingly the US are energy producers that can take actions to destabilize the region — the US by partially withdrawing, Russia by reinserting itself. Chart 11US Reducing Commitments In The Middle East True, the US still broadly shares with China the desire for stable oil prices — but its growing energy independence gives it the ability to reduce its commitments, upset the status quo, and create power vacuums that are detrimental to stability until a new regional equilibrium is established. Both the Obama and Trump administrations have demonstrated this erratic tendency (Chart 11). Russia has gotten closer to China, but it also is regaining strategic influence in the Middle East and has an interest in keeping the region divided and unpredictable. This is advantageous for an oil exporter outside the region with direct overland access to the Chinese market, but not advantageous for China. The above situation encapsulates the Geopolitical Strategy theme of multipolarity, or great power competition. The Middle East is in transition and the US strategic deleveraging ensures there will not be a stable order in the near term. Chinese investment can increase the region’s economic diversification, productivity, and potential GDP. But China’s financial limitations, US foreign policy, Russian foreign policy, and the region’s chronic instability will jeopardize those positive effects. Bottom Line: China’s influence in the Middle East is growing, particularly with the Gulf Arab states. However, this process exists within the context of competition with a number of other powers, ensuring that the Gulf Arab states still face extreme uncertainty and instability in attempting to reform. The US election is a critical juncture for US policy toward Iran and hence for the Mideast and China. While the US conflict with China will wax and wane across future administrations, the 2020 election will determine whether the US conflict with Iran gets better or worse in the next 1 – 3 years. Ultimately, we would expect the US to focus on pressuring China. But its latent strength in the Middle East is a tool for doing so. China’s growing role in the region will not ensure stability.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1High Anxiety: The Trade War and China’s Oil and Gas Supply Security, by Dr. Erica Downs, provides an excellent analysis of President Xi Jinping’s all-out drive to make China self-sufficient in oil and gas. It was published by Columbia University’s Center on Global Energy Policy November 12, 2019. The drive toward oil and gas self-sufficiency is described in local media as a war, as Dr. Downs notes: “In August 2018, (China National Petroleum Corp.) leaders met to discuss Xi’s directive and agreed to launch a ‘major offensive war’ on domestic exploration and development to enhance national energy security.” 2 Please see Chinese state firms mull up to US$10 billion investment in Saudi oil giant Aramco’s IPO published by the South China Morning Post November 7, 2019. The article also notes the Russian Direct Investment Fund also is considering taking a stake in the IPO. 3 $2.27 trillion is the upper end of a range generated by Bank of America. Please see Some banks dealing with Saudi Aramco IPO say company may be worth $1.5 trillion or even less, published by The Japan Times November 4, 2019, for additional estimates from banks involved in the deal. 4 The company’s 658-page prospectus also details business risks including terrorism, the attacks on Abqaiq and Khurais, and market-related financial risks. Not included is the size of the float – presumably that will be sized based on bids received – and how much of it will be allocated to individuals vs. institutions, who will be bidding for shares from November 17th to the 28th, and from the 17th to Dec. 4, respectively, when the issue is expected to price. The shares could be trading on December 11, 2019, on the Saudi stock Exchange, the Tadawul. No mention is made of a listing on an international exchange – e.g., London, Hong Kong, Tokyo, New York. 5 Please see OPEC says Saudi gave assurances Aramco IPO won’t affect commitment to group deals published November 13, 2019, by uk.reuters.com. 6 Please see Glimpses of China’s energy future, published by The Oxford Institute For Energy Studies in September 2019. The Institute summarized CNPC’s 2050 outlook to derive these estimates. 7 Please see footnote 1 above. 8 Please see ضد الواسطة , an Arabic phrase meaning “Against Wasta,” a practice that roughly translates as reciprocity in formal and informal dealings. This Special Report was published November 16, 2017, and is available at ces.bcaresearch.com. 9 Please see China’s Great Game In The Middle East, published by the European Council on Foreign Relations in October. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades